Contemporary Quantitative Finance: Essays in Honour of Eckhard Platen

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Contemporary Quantitative Finance

Carl Chiarella Alexander Novikov Editors

Contemporary Quantitative Finance Essays in Honour of Eckhard Platen

Editors Carl Chiarella Alexander Novikov School of Finance and Economics Department of Mathematical Sciences The University of Technology, Sydney P.O. Box 123, Broadway 2007 NSW Australia [email protected] [email protected]

ISBN 978-3-642-03478-7 e-ISBN 978-3-642-03479-4 DOI 10.1007/978-3-642-03479-4 Springer Heidelberg Dordrecht London New York Library of Congress Control Number: 2010930919 Mathematics Subject Classification (2000): 49Kxx, 49Nxx, 60G35, 62M05, 60G70, 65Mxx © Springer-Verlag Berlin Heidelberg 2010 This work is subject to copyright. All rights are reserved, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilm or in any other way, and storage in data banks. Duplication of this publication or parts thereof is permitted only under the provisions of the German Copyright Law of September 9, 1965, in its current version, and permission for use must always be obtained from Springer. Violations are liable to prosecution under the German Copyright Law. The use of general descriptive names, registered names, trademarks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. Cover design: WMXDesign GmbH, Heidelberg Printed on acid-free paper Springer is part of Springer Science+Business Media (www.springer.com)

Preface

This volume contains a collection of papers dedicated to Professor Eckhard Platen to celebrate his 60th birthday, which occurred in 2009. The contributions have been written by a number of his colleagues and co-authors. All papers have been reviewed and presented as keynote talks at the international conference “Quantitative Methods in Finance” (QMF) in Sydney in December 2009. The QMF Conference Series was initiated by Eckhard Platen in 1993 when he was at the Australian National University (ANU) in Canberra. Since joining UTS in 1997 the conference came to be organised on a much larger scale and has grown to become a significant international event in quantitative finance. Professor Platen has held the Chair of Quantitative Finance at the University of Technology, Sydney (UTS) jointly in the Faculties of Business and Science since 1997. Prior to this appointment, he was the Founding Head of the Centre for Financial Mathematics at the Institute of Advanced Studies at ANU, a position to which he was appointed in 1994. Eckhard completed a PhD in Mathematics at the Technical University in Dresden in 1975 and in 1985 obtained his Doctor of Science degree (Habilitation degree in the German system) from the Academy of Sciences in Berlin where he headed the Stochastics group at the Weierstrass Institute. Eckhard has served on the editorial boards of many distinguished journals, and he is currently a member of the following Editorial Boards: Mathematical Finance, Acta Applicandae Mathematicae, Communications on Stochastic Analysis, Monte Carlo Methods and Applications, Quantitative Finance, the new Bocconi-Springer Book Series and an adviser to Asia-Pacific Financial Markets. Eckhard worked initially on the development of the theory and applications of numerical methods for stochastic differential equations, at first in the context of engineering applications the 1970’s and 1980’s and then continuing this work in 1990–2000’s with a strong focus on finance applications. He uncovered the key role in the derivation of high order weak and strong approximations for stochastic differential equations (both with or without jump components) played by a stochastic analogue of the Taylor expansion, also called the Wagner-Platen (or, also PlatenWagner) formula. This result has been generalised and extended in numerous papers, the best reference being the monographs Kloeden P. and Platen E. (1999) [2] v

vi

Preface

and Kloeden P., Platen E. and Shurz H. (2003) [3]; both of which have so far had three editions at Springer. From the beginning of 1990’s Eckhard turned the focus of his research interests to different aspects of quantitative finance. At first his work was devoted to developing general principles for the modelling of incomplete financial markets. Over the last decade he has worked on essential problems with the existing methodologies for derivative pricing and risk measurement. His benchmark approach, described in the monograph Platen & Heath (2006) [4], models the dynamics of the financial market by using the growth optimal portfolio (GOP). In the context of portfolio optimisation the GOP serves as a benchmark, and for the purpose of pricing as well as hedging it can be taken as the numeraire. Under this approach the real world measure is used as the pricing measure and so the approach can be used also in those cases in which a risk neutral measure does not exist. One of the advantages of this approach is the fact that it allows one to establish a link between modern mathematical finance methodologies and the more classical ones that are still in wide use, especially among practitioners in both the finance and insurance industries. The benchmark approach is furthermore in line with some current investigations that take into account the fact that in various financial applications a local martingale may not be a martingale (see for example the article by Hulley in this volume). There are in fact market models for which an equivalent risk neutral measure does not exist because the corresponding Radon-Nikodým derivative is a strict supermartingale. A discrete time version of the benchmark approach with a view to insurance applications was discussed in Bühlmann & Platen (2003) [1]. As in the case of financial pricing the standard actuarial pricing rule is obtained as a particular case of fair pricing when the contingent claim is independent of the growth optimal portfolio. In addition to the above, Eckhard has published a number of papers on diverse subjects including stochastic control, modelling of stochastic vibrations, modelling of interacting stochastic particle systems and modelling of charge transport. During his career Eckhard has published four books and about 150 academic articles. His most recent book with the late Nicola Bruti-Liberati [5] contains his recent research on the numerical solution of stochastic differential equations with jumps. His current research includes estimation of discretely observed financial markets (with Michael Sørenson), study of transition densities for diffusion processes (with Mark Craddock), and work on estimation techniques in search of the most appropriate financial market model (with Renata Rendek). The papers in this collection fall broadly under three headings. The first group of papers of D. Fernholz and I. Karatzas; C. Kardaras; H. Hulley and M. Schweizer; H. Hulley; W. Runggaldier and G. Galesso deal with various current issues relating to martingale measures in the context of the arbitrage approach to financial markets; the second group of papers by Bao, Delbaen and Hu; Cohen and Elliott, and Imkeller, Reis and Zhang deal with certain recent advances in backward stochastic differential equations for the purposes of utility maximisation and hedging. The third group of eleven papers contains various applications, five on interest rate modelling and the rest on diverse applications from stochastic partial differential equations and portfolio choice to maximum likelihood estimation for integrated diffu-

Preface

vii

sion processes. Many of the authors are amongst the leading figures internationally in mathematical and quantitative finance. The editors would like to thank all of the authors for their contributions and the anonymous reviewers for their prompt and helpful reports. We would particularly thank both authors and reviewers for responding in such a timely manner to the extreme dead-line pressure. We would like to thank Ms. Stephanie Ji-Won Ough for all her work in preparing the final draft of the book in the Springer layout. Finally we would like to thank the staff at the publisher Springer Verlag for assisting the publishing process in many ways. Sydney, Australia

Carl Chiarella Alexander Novikov

References 1. Bühlmann, H., Platen, E.: A discrete time benchmark approach for insurance and finance. ASTIN Bull. 33(2), 153–172 (2003) 2. Kloeden, P.E., Platen, E.: Numerical Solution of Stochastic Differential Equations. Applications of Mathematics 23. Springer, Berlin, 632 pp., ISBN 3-540-54062-8, (1992), (1995), Third extensively revised printing (1999) 3. Kloeden, P.E., Platen, E., Schurz, H.: Numerical Solution of SDE Through Computer Experiments. UNIVERSITEXT-Series (with diskette). Springer, Berlin, 294 pp., ISBN 3-540-57074-8, (1994), Second revised printing (1997), Corrected third printing (2003) 4. Platen, E., Heath, D.: A Benchmark Approach to Quantitative Finance. Springer Finance. Springer, Berlin, 700 pp., ISBN-10 3-540-26212-1 (2006), Corrected second printing (2010) 5. Platen, E., Bruti-Liberati, N.: Numerical Solution of SDEs with Jumps in Finance. Applications of Mathematics. Springer, Berlin, 882 pp., (2010)

Contents

Probabilistic Aspects of Arbitrage . . . . . . . . . . . . . . . . . . . . . . Daniel Fernholz and Ioannis Karatzas Finitely Additive Probabilities and the Fundamental Theorem of Asset Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Constantinos Kardaras M6 —On Minimal Market Models and Minimal Martingale Measures . . Hardy Hulley and Martin Schweizer

1

19

35

The Economic Plausibility of Strict Local Martingales in Financial Modelling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Hardy Hulley

53

A Remarkable σ -finite Measure Associated with Last Passage Times and Penalisation Problems . . . . . . . . . . . . . . . . . . . . . . . . . . Joseph Najnudel and Ashkan Nikeghbali

77

Pricing Without Equivalent Martingale Measures Under Complete and Incomplete Observation . . . . . . . . . . . . . . . . . . . . . . . . . . . . Wolfgang J. Runggaldier and Giorgia Galesso

99

Existence and Non-uniqueness of Solutions for BSDE . . . . . . . . . . . 123 Xiaobo Bao, Freddy Delbaen, and Ying Hu Comparison Theorems for Finite State Backward Stochastic Differential Equations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135 Samuel N. Cohen and Robert J. Elliott Results on Numerics for FBSDE with Drivers of Quadratic Growth . . . 159 Peter Imkeller, Gonçalo Dos Reis, and Jianing Zhang ix

x

Contents

Variance Swap Portfolio Theory . . . . . . . . . . . . . . . . . . . . . . . 183 Dilip B. Madan Stochastic Partial Differential Equations and Portfolio Choice . . . . . . 195 Marek Musiela and Thaleia Zariphopoulou Issuers’ Commitments Would Add More Value than Any Rating Scheme Could Ever Do . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217 Carlos Veiga and Uwe Wystup Pricing and Hedging of CDOs: A Top Down Approach . . . . . . . . . . . 231 Damir Filipović and Thorsten Schmidt Constructing Random Times with Given Survival Processes and Applications to Valuation of Credit Derivatives . . . . . . . . . . . . . . . 255 Pavel V. Gapeev, Monique Jeanblanc, Libo Li, and Marek Rutkowski Representation of American Option Prices Under Heston Stochastic Volatility Dynamics Using Integral Transforms . . . . . . . . . . . . . . . 281 Carl Chiarella, Andrew Ziogas, and Jonathan Ziveyi Buy Low and Sell High . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317 Min Dai, Hanqing Jin, Yifei Zhong, and Xun Yu Zhou Continuity Theorems in Boundary Crossing Problems for Diffusion Processes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335 Konstantin A. Borovkov, Andrew N. Downes, and Alexander A. Novikov Binomial Models for Interest Rates . . . . . . . . . . . . . . . . . . . . . . 353 John van der Hoek Lognormal Forward Market Model (LFM) Volatility Function Approximation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369 In-Hwan Chung, Tim Dun, and Erik Schlögl Maximum Likelihood Estimation for Integrated Diffusion Processes . . . 407 Fernando Baltazar-Larios and Michael Sørensen

Probabilistic Aspects of Arbitrage Daniel Fernholz and Ioannis Karatzas

Abstract Consider the logarithm log(1/U (T , z)) of the highest return on investment that can be achieved relative to a market with Markovian weights, over a given time-horizon [0, T ] and with given initial market weight configuration Z (0) = z. We characterize this quantity (i) as the smallest amount of relative entropy with respect to the Föllmer exit measure, under which the market weight process Z (·) is a diffusion with values in the unit simplex Δ and the same covariance structure but zero drift; and (ii) as the smallest “total energy” expended during [0, T ] by the respective drift, over a class of probability measures which are absolutely continuous with respect to the exit measure and under which Z (·) stays in the interior Δo of the unit simplex at all times, almost surely. The smallest relative entropy, or total energy, corresponds to the conditioning of the exit measure on the event {Z (t) ∈ Δo , ∀ 0 ≤ t ≤ T }; whereas, under this “minimal energy” measure, the portfolio π (·) generated by the function U (· , ·) has the numéraire and relative log-optimality properties. This same portfolio π (·) also attains the highest possible relative return on investment with respect to the market.

1 Introduction The pioneering work of Fernholz [6] demonstrated that, under appropriate conditions, it is possible systematically to outperform a market portfolio over sufficiently I. Karatzas is on leave from the Department of Mathematics, Columbia University, Mail Code 4438, New York, NY 10027. e-mail: [email protected] D. Fernholz Daniel Fernholz LLC, 603 West 13th Street, Suite 1A-440, Austin, TX 78701, USA e-mail: [email protected] I. Karatzas () INTECH Investment Management LLC, One Palmer Square, Suite 441, Princeton, NJ 08542, USA e-mail: [email protected] C. Chiarella, A. Novikov (eds.), Contemporary Quantitative Finance, DOI 10.1007/978-3-642-03479-4_1, © Springer-Verlag Berlin Heidelberg 2010

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2

D. Fernholz and I. Karatzas

long time horizons. Since then there has been an effort to understand various aspects of such “relative arbitrage”: its implementation on arbitrary time horizons, the nature and behavior of portfolios that implement it, pricing and hedging in the context of strict local martingale deflators, etcetera. These efforts are summarized in the survey paper [7]. The fairly recent article [5] addresses an issue that arises naturally in this context: if arbitrage exists on a given time-horizon relative to a given market, what is the “best possible” arbitrage of this type? how can it be characterized? what portfolio(s) implement it? Within a Markovian weight model and under suitable regularity conditions, it was shown in [5] that the reciprocal U (T , z) ∈ (0, 1] of the highest relative return on investment, that can be achieved with respect to the market over a given time-horizon [0, T ] and with initial market weight configuration Z (0) = z in the interior Δo of the unit simplex Δ, is equal to the probability under an auxiliary that the process of relative market weights Z (·) stays in Δo throughmeasure Q is the celebrated Föllmer exit out the time interval [0, T ]. The probability measure Q measure [9, 10]: the original measure P is absolutely continuous with respect to it; it renders Z (·) a Δ-valued diffusion with the same covariance structure but zero drift, thus a martingale; and it anoints Z (·) with the “numéraire property”, of a portfolio that cannot be outperformed. It was also shown in [5] that U (· , ·) satisfies a linear, second-order partial differential equation on (0, ∞) × Δo , determined entirely on the basis of the covariance structure of the underlying model. The function U (· , ·) is the smallest nonnegative supersolution of this equation subject to U (0, ·) ≡ 1 on π (·) which attains this best possible relative arbitrage is the Δo , and the portfolio one generated by this function in the sense of Fernholz [6, p. 46]. We show here that this portfolio π (·) has itself the numéraire and log-optimality | Z (t) ∈ Δo , properties, but under yet another probability measure P (·) = Q(· ∀ 0 ≤ t ≤ T ), the conditioning of the Föllmer measure on the event that the boundary of the simplex is not attained by the process Z (·) during [0, T ]. This P has a further characterization as the probability measure whose associated drift ϑ P (·) keeps the process Z (·) inside of Δo throughout [0, T ] with the smallest amount T of “total energy”, or effort, (1/2) E P 0 ϑ P (t)2 dt, over all probability measures with P(Z (t) ∈ Δo , ∀ 0 ≤ t ≤ T ) = 1; it is also the measure with the smallPQ over this same class, and this smallest value is the est relative entropy HT (P | Q) logarithm log(1/U (T , z)) of the highest achievable return on investment relative to the market. We call this measure P “minimal energy measure”. The paper is organized as follows. Sections 2 and 3 provide necessary background material and set up the model. Section 4 introduces the notions of relative arbitrage and of the minimal capital necessary to implement it, as well as of the Föllmer exit measure and its properties. We also describe in Sect. 4 the analytical properties of the function U (· , ·), and of the “optimal arbitrage” portfolio π (·) generated by it. The conditional measure P is introduced in Sect. 5, and under it the numéraire and relative log-optimality properties of π (·) are developed. Section 6 establishes the minimum relative entropy and stochastic control characterizations of P , building on a Schrödinger-type equation satisfied by the function log(1/U (· , ·)) and on the relation of this equation to one of the Hamilton-Jacobi-Bellman (HJB)

Probabilistic Aspects of Arbitrage

3

type. We conclude in Sect. 7 with several additional characterizations of the optimal arbitrage function, including one that involves a zero-sum stochastic game, and with a compilation of results.

2 Preliminaries On a given filtered probability space (Ω, F , P), F = {F (t)}0≤t 0 in the ith asset, for each i = 1, . . . , n. With this interpretation, the dynamics of the wealth process V w,π (·), corresponding to portfolio π(·) and initial wealth w ∈ (0, ∞), are given by n d V w,π (t) dXi (t) = , πi (t) V w,π (t) Xi (t)

V w,π (0) = w .

(1)

i=1

The collection of all portfolios will be denoted by Π . Portfolios that take values in Δ will be called “long-only”; the most conspicuous of these is the market portfolio Z (·), which actually takes values in Δo and generates wealth V w,Z (·) = wX(·)/X(0) proportional to the total market capitalization at all times. If one is interested in performance relative to the market, it makes sense to consider for any given portfolio π(·) ∈ Π the ratio, or relative performance, Y q,π (·) := V qX(0),π (·) / X(·) = V qX(0),π (·) / V X(0),Z (·) ;

(2)

here the scalar q > 0 measures initial wealth w = qX(0) as a proportion of total market capitalization at time t = 0. The dynamics of this relative performance are shown to be n d Y q,π (t) dZi (t) = , πi (t) Y q,π (t) Zi (t) i=1

Y q,π (0) = q .

(3)

4


2.1 Change of Variables It is occasionally convenient to describe a portfolio π(·) = (π1 (·), . . . , πn (·)) in terms of the vector ψ(·) = (ψ1 (·), . . . , ψn (·)) of its scaled relative weights ψi (·) := πi (·) / Zi (·) ,

i = 1, . . . , n .

This allows us to rewrite the relative performance dynamics (3) simply as n d Y q,π (t) = ψi (t) dZi (t) = ψ (t) dZ (t) , Y q,π (t)

Y q,π (0) = q .

(4)

i=1

Since ni=1 dZi (t) = 0, the vector ψ(t) of scaled portfolio weights need be specified only modulo a scalar factor; then ψ1 (t), . . . , ψn (t) are recovered from the ordinary portfolio weights n πi (t) = Zi (t) ψi (t) + 1 − Zj (t)ψj (t) , i = 1, . . . , n . (5) j =1

3 The Model We shall postulate from now onwards an Itô process model for the Δo -valued relative market weights Z (·) = (Z1 (·), . . . , Zn (·)) process, of the form (6) dZ (t) = s Z (t) dW (t) + ϑ(t) dt , Z (0) = z ∈ Δo . Here W (·) is an n-dimensional P-Brownian motion; ϑ(·) is an n-dimensional, proT gressively measurable and locally square-integrable process, i.e., 0 ϑ(t)2 dt < ∞ holds P-a.s. for every T ∈ (0, ∞); and the volatility structure is characterized in terms of s(·) = (si (·))1≤i, ≤n , a matrix-valued function with continuous components si : Δ → R that satisfy the condition ni=1 si (·) ≡ 0 for all = 1, . . . , n. We shall assume that the corresponding covariance matrix a(z) := s(z) s (z) ,

z∈Δ

(7)

has rank n − 1 for every z ∈ Δo (cf. Lemma 3.1 in [7]), as well as rank k in the interior d o of every k-dimensional sub-simplex d ⊂ Γ , k = 1, . . . , n − 2. If, on some given time-horizon [0, T ] of finite length, we can write ϑ(t) = Θ(T − t, Z (t)), 0 ≤ t ≤ T for some continuous function Θ : [0, T ] × Δ → Rn , we shall say that on this time-horizon [0, T ] the resulting diffusion (8) dZ (t) = b T − t, Z (t) dt + s(Z (t)) dW (t) , Z (0) = z ∈ Δo , with b(τ, z) := s(z)Θ(τ, z), constitutes a Markovian Market Weight (MMW) model.


5

3.1 Numéraire and Log-Optimality Properties Consider now two portfolios π(·), ν(·) with corresponding scaled relative weights ψi (·) = πi (·)/Zi (·) and ϕi (·) = νi (·)/Zi (·), i = 1, . . . , n. An application of Itô’s rule in conjunction with (4) gives q,π

q,π

Y (t) Y (t) = ψ(t) − ϕ(t) dZ (t) − a Z (t) ϕ(t) dt ; (9) d Y q,ν (t) Y q,ν (t) whereas, on the strength of (6), the last term (in brackets) is s Z (t) dW (t) + s Z (t) ϑ(t) − s Z (t) ϕ(t) dt . The finite variation part of this expression vanishes, if we select the portfolio ν(·) as in (5) with scaled relative weights ϕ(·) = (ϕ1 (·), . . . , ϕn (·)) that satisfy s Z (·) ϕ(·) = ϑ(·) . (10) P

Thus, for ν(·) ≡ ν P (·) selected this way, the ratio Y q,π (·)/Y q,ν (·) is, for any portfolio π(·) ∈ Π , a positive local martingale, thus also a supermartingale. We express this by saying that the portfolio ν P (·) has the “numéraire property” (e.g., [18, 21, 24] and the references there). As was observed in [7, 18], no arbitrage relative to such a portfolio is possible over any finite time-horizon. Note also that, if ϑ(·) ≡ 0, we can select ϕ(·) ≡ 0 in (10), so the resulting market portfolio Z (·) from (5) has then the numéraire property. With ν P (·) selected as in (5) from scaled relative weights ϕ(·) = (ϕ1 (·), . . . , ϕn (·)) that satisfy (10), the expression of (9) becomes P P d Y q,π (t) / Y q,ν (t) = Y q,π (t) / Y q,ν (t) ψ(t) − ϕ(t) s Z (t) dW (t) and yields d log

Y q,π (t)

P Y q,ν (t)

= ψ(t) − ϕ(t) s Z (t) dW (t)

1 ψ(t) − ϕ(t) a Z (t) ψ(t) − ϕ(t) dt . 2 We deduce as in [18, 19] (see also [1, 2]) the relative log-optimality property of ν P (·): for every portfolio π(·) ∈ Π and (T , q) ∈ (0, ∞)2 , we have P Y q,π (T ) Y q,ν (T ) 1 P T ≤ E P log = E ϑ(t)2 dt . (11) E P log q q 2 0 −

4 Relative Arbitrage Let us recall briefly some results from [5]. Within a market model as in the previous section, and for a given time-horizon [0, T ] and initial market weight configuration Z (0) = z ∈ Δo , we introduce the relative arbitrage function U (T , z) := inf q > 0 : ∃ π(·) ∈ Π s.t. P Y q,π (T ) ≥ 1 = 1 . (12)

6


To wit, U (T , z) ∈ (0, 1] is the smallest relative initial wealth required at t = 0, in order to attain at time t = T relative wealth of (at least) 1 with respect to the market, P-a.s. Equivalently, the quantity (1/U (T , z)) gives the maximal relative amount by which the market portfolio can be outperformed over the time horizon [0, T ]. If U (T , z) = 1, it is not possible to outperform the market over [0, T ]; if, on the other hand, U (T , z) < 1, then for every q ∈ (U (T , z), 1) (and even for q = U (T , z), when the infimum in (12) is attained) there exists a portfolio πq (·) ∈ Π such that V 1,πq (T ) 1 ≥ > 1 holds P-a.s. 1,Z q V (T ) In the terminology of [7], each such πq (·) is then strong arbitrage relative to the market portfolio Z (·) over the time-horizon [0, T ]. Remark 1 It is shown in [7, Sect. 11] (see also [5]) that a sufficient condition leading to U (T , z) < 1, is that there exist a real constant h > 0 for which n i=1

zi

aii (z) ≥ h, zi2

∀ z ∈ Δo .

(13)

The expression on the left-hand side of this inequality is the average, weighted by market weight zi , of the variances aii (z)/zi2 of individual asset log-returns relative to the market and, as such, a measure of the market’s “intrinsic volatility”. The condition (13) posits a positive lower bound on this quantity as sufficient for U (T , z) < 1, i.e., for the possibility of outperforming the market. Here, we shall characterize U (T , z) in various equivalent ways, thus providing necessary and sufficient conditions for this possibility. Remark 2 A concrete example where (13) is satisfied concerns the model d log Xi (t) = (κ/Zi (t)) dt + 1/ Zi (t) dWi (t) for the log-capitalizations log Xi (t), i = 1, . . . , n with some constant κ ≥ 0 , or equivalently n dZi (t) = 2κ 1 − n Zi (t) dt + Zi (t) dWi (t) − Zi (t) Zk (t) dWk (t) k=1

for the market weight process Z (·). It is checked that the variances are of the Wright-Fisher type aii (z) = zi (1 − zi ) in this case, so (13) holds as an equality with h = n − 1 ≥ 1. For the details and analysis of this model see Sect. 12 in [5], as well as [15, 22].


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4.1 The Föllmer “Exit Measure” Under appropriate “canonical” conditions on the filtered measurable space (Ω, F ), the so-called Föllmer F = {F (t)}0≤t T , (T , z) ∈ (0, ∞) × Δo U (T , z) = Q (17) for the relative arbitrage function of (12), as the probability under the Föllmer measure (which we index here by the starting position Z (0) = z of the diffusion in (15)) that Z (·) has not reached the boundary Γ of the simplex by time t = T . Since each Zi (·) is a nonnegative Q-martingale, it is clear that on {Ti < ∞} we have Zi (Ti + u) = 0 , ∀ u ≥ 0, Q-a.s. Thus, the process Z (·) stays Q-a.s. on Γ once it gets there; and so on by induction, regarding the boundaries γ = d \ d o of lower-dimensional subsimplices d of Γ . For proofs of these claims we refer the reader to [5], as well as to [3, 4, 23, 25] and of course to the original work of Föllmer [9, 10]. It is also seen in [5] that T = inf{t ≥ 0 : Λ(t) = 0} holds Q-a.s., and that the relative arbitrage function of (12) admits the representation 1 z U (T , z) = E P , (18) Λ(T ) where now we index by the starting position Z (0) = z of the process Z (·) in (6) the original probability measure P. Under this measure, the deflator process · 1 1 · q = exp − ϑ (t) dW (t) − ϑ(t)2 dt ≡ (19) P q,ν Λ(·) 2 Y (·) 0 0

8


appearing in (18) is, of course, a strictly positive local martingale and supermartingale; here q > 0 is a constant, and ν P (·) the numéraire portfolio of Sect. 3.1. It may be helpful to think of the passage from the original measure P to the as a generalized Girsanov-like change of probability that “reFöllmer measure Q, moves the drift” in (6), when the deflator process 1/Λ(·) of (19) is a strict local martingale under P, i.e., when U (T , z) < 1. As Λ(·) can reach the origin with positive Q-probability, this is in general not an equivalent change of measure. Nonetheless, can the market weight process Z (·) is a Q-martingale, so the Föllmer measure Q be thought of as a “martingale measure” for the model under consideration.

4.2 The Functionally-Generated Portfolio It is shown in [5] that, under appropriate regularity conditions on the covariance structure a(·) and on the relative drift ϑ(·), the function U (· , ·) defined in (12) is of class C 1,2 on (0, ∞) × Δo and satisfies on this domain the equation Dτ U (τ, z) =

n n 1 aij (z) Dij2 U (τ, z) , 2

(20)

i=1 j =1

or equivalently Dτ U = 12 Tr(a D 2 U ); and that U (· , ·) is also the smallest nonnegative supersolution of this equation, subject to the initial condition U (0, z) ≡ 1 ,

∀ z ∈ Δo .

(21)

We shall use throughout the notation Dτ f = ∂f/∂τ , Di f = ∂f/∂xi , Df = (∂f/∂x1 , . . . , ∂f/∂xn ) for the gradient, and D 2 f = (Dij2 f )1≤i,j ≤n with Dij2 f = ∂ 2 f/∂xi ∂xj for the Hessian. Let us consider the process (t) := U T − t, Z (t) 1{T >t} , 0 ≤ t ≤ T ; (22) Y (0) = U (T , z) and Y (T ) = 1, P-a.s. An application of Itô’s rule leads it satisfies Y now, in conjunction with (20) and (6), to the P-dynamics (t) = Y (t) ψ (t) dZ (t) dY (23) as in (4), with

Di U ψi (t) := T − t, Z (t) = Di log U T − t, Z (t) , U

i = 1, . . . , n (24)

and, via (5), to the functionally-generated (in the terminology of [6, p. 46]) portfolio πi (t) := Zi (t) Di log U T − t, Z (t) + 1 −

n j =1

Zj (t) Dj log U T − t, Z (t) .

(25)


9

If U (T , z) < 1, this portfolio implements the optimal arbitrage under the original probability measure, in the sense that with q = U (T , z) we have π (·) ≡ Y q, (·) , Y

P-a.s.

(26)

as in (2), (3). In particular, we see that the infimum in (12) is then attained.

5 Induced Drifts One potentially intriguing aspect of the arbitrage function in (12), and of the portfolio (25) which is generated by it and implements the optimal arbitrage, is that they appear not to depend at all on the drift vector s(Z (·)) ϑ(·) of the Itô process Z (·) in (6). That is, as long as we know the covariance structure of (7), we can construct the function U (· , ·), at least in principle, as the smallest nonnegative (super)solution of the Cauchy problem (20), (21), and from U (· , ·) the portfolio π (·) of (25) that attains the prescribed amount of arbitrage. Even if we were given the drift as well, we would not, in general, be able to improve upon this optimal arbitrage. Of course, the drift is not entirely irrelevant; we have assumed, for one, that it satisfies certain regularity conditions. More significantly, we have posited that under the measure P the market weight process Z (·) never hits the boundary Γ of the simplex; this assumption alone places non-trivial restrictions on the drift term or, equivalently, on the “relative market price of risk” process ϑ(·) of (6); cf. [13, Chaps. 9 and 11].

5.1 Conditioning One way to construct such a drift is as follows. We reverse the above procedure on the canonical filtered measurable space and start with a probability measure Q (Ω, F ), F = {F (t)}0≤t T , A ∈ F (T ) (27) P (A) := Q in the notation of (16). In other words, the distribution of the market weight process of Z (·) under P on F (T ) is the same as the conditional distribution under Q the process Z (·), conditioned on the event that this process has not reached the boundary Γ of the simplex by time T . An elementary computation gives (t) U T − t, Z (t) d P Y 1{T >t} = = =: ΛP (t) , 0 ≤ t ≤ T , (28) U (T , z) Y (0) d Q F (t)

10


(·) of (22) is a Q-martingale, Q-a.s. In particular, the process Y so the representation (17) follows then from optional sampling and (21). Repeating the steps of our analysis in Sect. 4.2, now in reverse, we see that the Q-martingale ΛP (·) of (28) can be cast in the manner of (14), with ϑ(·) replaced by the n-dimensional process ϑ P (·) = Θ T − · , Z (·) , where Θ (τ, z) := s(z) D log U (τ, z) . (29) Moreover, (6) takes now the form of an MMW model dZ (t) = a Z (t) D log U T − t, Z (t) dt + s Z (t) dW P (t) , Z (0) = z ∈ Δo (·) − · ϑ P (t) dt an n-dimensional P -Brownian motion. with W P (·) := W 0

(30)

5.2 Numéraire and Log-Optimality Properties of π (·) It is clear from (29), (30), (10) and (24) that the portfolio π (·) of (25) has the numéraire and log-optimality properties under the probability measure P of (27); i.e., π (t), 0 ≤ t ≤ T is a P -supermartingale, and the process Y q,π (t)/Y q, π (t) Y q,π (t) Y q, 1 P t ≤ E P log = E ϑ P (u)2 du E P log q q 2 0

(31)

holds for q > 0, t ∈ [0, T ] on the strength of (11), for every π(·) ∈ Π . In the notation of Sect. 3.1, we can thus write π (·) ≡ ν P (·). We may characterize the strategy that achieves optimal arbitrage over [0, T ] that generates driftless, Markovian market thus: Start with a probability measure Q on the event weights as in (15); then construct the measure P by conditioning Q {T > T }; finally, find a portfolio π (·) that maximizes expected logarithmic relative returns under P . Let us also note that, in the context of the MMW model (30) with ϑ(·) ≡ ϑ P (·) as in (29), the representation (18), (19) can be cast on the strength of (28), (26) as U (T , z) =

q 1 , = q, Y π (T ) ΛP (T )

P -a.s.

(32)

6 Relative Entropy The definitions in (14) and (28) suggest a re-writing of (31) for t = T , q > 0 as π (T )

Y q,π (T ) Y q, ≤ E P log = E P log ΛP (T ) , E P log q q ∀ π(·) ∈ Π , (33)


11

and thence a further interpretation of the arbitrage function and of the portfolio π (·) generated by it, this time in terms of relative entropy. In particular, we claim that with L := log(1/U ) we have the string of equalities ) := E P log d P /d Q HT ( P | Q F (T ) T

1 P P P = E log Λ (T ) = E ϑ P (t)2 dt 2 0 1 P T E DL T − t, Z (t) a Z (t) DL T − t, Z (t) dt = 2 0 = log 1/U (T , z) . (34) Proof of (34), (33) Let us start by observing from the Cauchy problem of (20), (21) that the function L = log(1/U ) satisfies the semilinear Schrödinger-type equation Dτ L(τ, z) =

n n 1 aij (z) Dij2 L − Di L · Dj L (τ, z) 2

(35)

i=1 j =1

or equivalently Dτ L = 12 Tr(a D 2 L) initial condition L(0, ·) ≡ 0 on Δo .

−

1 2 (DL) a (DL)

on (0, ∞) × Δo , and the

In conjunction with (30) and the notation of (29), this implies that the process 1 · Θ T − t, Z (t) 2 dt + L T − · , Z (·) = L(T , z) − M (·) , (36) 2 0 · with M (·) := 0 (Θ (T − t, Z (t))) dW P (t), is a nonnegative P -local martingale, thus a P -supermartingale; in particular, T P Θ T − t, Z (t) 2 dt ≤ 2 L(T , z) . (37) E 0

We have used here the identity L(0, ·) ≡ 0 on Δo , and the fact that the market weight process Z (·) takes values in Δo , P -a.s. The quadratic variation of the P -local martingale M (·) of (36) is given by · M (·) = 0 Θ (T − t, Z (t))2 dt, so (37) implies that M (·) is actually a (square-integrable) martingale under P . In particular, (37) holds as equality and the last equation in (34) holds. The only other claim in (34) that needs discussion, is its third equality; but now this follows from the work of H. Föllmer, namely, Proposition 2.11 in [12] and Lemma 2.6 in [11]. As for (33), this is now just a restatement of (31).

6.1 Stochastic Control Emboldened by all this, let us consider on the filtered measurable space (Ω, F ), F = on {F (t)}0≤t≤T the collection P of all probability measures that satisfy P Q F (T ) and P(Z (t) ∈ Δo , ∀ 0 ≤ t ≤ T ) = 1.

12


The measure P of Sect. 5.1 belongs to P, as does the generic probability measure of our model introduced in Sect. 3. It is not hard to see that P consists of precisely those probability measures P on (Ω, F ) which are absolutely continuous with respect to P on F (T ). The elements of P are absolutely continuous with re but, in general, not equivalent: the case Q z (Z (t) ∈ Δo , ∀ 0 ≤ t ≤ T ) = spect to Q U (T , z) < 1 is the most interesting. F (t) = ΛP (t), 0 ≤ For every P ∈ P, the nonnegative Q-martingale (d P/d Q)| t ≤ T admits a representation of the form (14) for an appropriate n-dimensional process ϑ(·) ≡ ϑ P (·) which: is F-progressively measurable; is square-integrable on T T on {T > [0, T ], P-a.s.; and satisfies 0 ϑ(t)2 dt < 0 ϑ(t)2 dt = ∞, Q-a.s. T }. The vector Z (·) of relative market weights is under P an Itô process of the form dZ (t) = s(Z (t)) (dW P (t) + ϑ P (t) dt), Z (0) = z ∈ Δo as in (6), with values in Δo and W P (·) ≡ W (·) an n-dimensional P-Brownian motion. Finally, just as before, the on F (T ) is given as relative entropy of P with respect to the probability measure Q

) := EP log d P/d Q HT ( P | Q = EP log ΛP (T ) F (T ) 1 P T = ϑ P (t)2 dt . (38) E 2 0 The crucial next step is a simple observation that goes back at least to Holland [17] and Fleming [8], namely, that the Schrödinger equation (35) can be cast in the Hamilton-Jacobi-Bellman (HJB) form 1 2 1 Dτ L = Tr a D L + minn (DL) s θ + θ 2 ; θ∈R 2 2 and that the minimization is attained at θ = − s DL, just as in (29). Of course, every time an HJB equation makes its appearance, an associated stochastic control problem cannot lag very far behind. In our context, this problem amounts to minimizing, over all probability measures P ∈ P, the “total energy” T (1/2) EP 0 ϑ P (t)2 dt during [0, T ], of the drift term in (6) that keeps the relative weight process Z (·) inside of Δo during this time-horizon. Equivalently, from (38), this amounts to finding a probability measure that minimizes the relative en ) over all P ∈ P. The answer to (both incarnations of) this question tropy HT ( P | Q should now be obvious; it is the subject of the proposition that follows. It is instructive to consider first the subclass P† ⊆ P of probability measures 1/2 T 2 † P Θ T − t, Z (t) P := P ∈ P : E dt 0. = max EP log q π(·) ∈ Π P

2

T

ϑ P (t)2 dt

0

(42)

14


Proof In light of (33) and (34), only the second equation needs justification. For an arbitrary P ∈ P we have P(T > T ) = 1, so P HT ( P | Q ) = E log d P/d Q F (T ) = d P. log d P/d Q F (T ) {T >T }

)|F (T ) = 1/U (T , z), Q-a.s. But (28) gives (d P /d Q on the event {T > T }, thus ) = log d P/d P F (T ) + log 1/U (T , z) d P HT ( P | Q {T >T }

). = HT ( P | P ) + log 1/U (T , z) ≥ log 1/U (T , z) = HT ( P | Q

According to this result, the quantity log(1/U (T , z)) – logarithm of the maximal relative amount by which the market portfolio can be outperformed over the horizon [0, T ], P-a.s. for every P ∈ P – is also the maximal P -expected-logoutperformance of the market during [0, T ] that can be achieved over all π(·) ∈ Π . On the other hand, we have shown that the probability measure P of (27) has the over the collection smallest relative entropy with respect to the Föllmer measure Q, P P; and that its associated drift ϑ (·) keeps the relative weight process Z (·) inside Δo with the smallest amount of total energy. For this reason we shall call P minimal energy measure for the process Z (·). This terminology echoes that of Frittelli [14] (see also [16]), where the term “minimal entropy martingale measure” is used in a different context (the valuation of contingent claims in incomplete markets) and with an eye towards banishing arbitrage rather than implementing it in the best way when it exists. In that context, the Minimal Entropy Martingale (MEM) measure renders the underlying price process a martingale, which our P in general does not.

6.2 Stochastic Game Having come thus far, let us also note that (33) can be written as π (T ) Y q,π (T ) Y q, ≤ E P log E P log q q

P P ) = log 1/U (T , z) log Λ (T ) = HT ( P | Q =E π (T ) Y q, , ∀ P, π(·) ∈ P × Π . (43) = E P log q For this last equality we have used (28) in the form π (T )/Y (0) = U (0, Z (T ))/U (T , z) 1{T >T } , ΛP (T ) = Y q, (T )/q = Y

P-a.s.


15

and yet again (21), (26) as well as the fact P(Z (t) ∈ Δo , ∀ 0 ≤ t ≤ T ) = 1, to π (T )/q = 1/U (T , z) holds P-a.s. obtain that ΛP (T ) = Y q, This gives also the following strengthening of (32), (18): for every q > 0, P ∈ P we have 1 1 q P P = P =E U (T , z) = E P P q,ν Λ (T ) Λ (T ) Y (·) q = q, , P-a.s. (44) Y π (T ) • We conclude from (43) that the pair (P , π (·)) is a saddle point for the Stochastic Game with value Y q,π (T ) log 1/U (T , z) = min max EP log P ∈ P π(·) ∈ Π q q,π Y (T ) . = max min EP log q π(·) ∈ Π P ∈ P The “maximizer” in this zero-sum game is an investor who tries to outperform the market by his choice of portfolio π(·) ∈ Π ; whereas we can think of the “minimizer” as Nature, or the goddess Tyche herself, who tries to thwart the investor’s efforts by choosing the probability measure P ∈ P, or equivalently its induced drift ϑ P (·) ≡ ϑ(·), to the investor’s detriment.

7 Conclusion We recapitulate and summarize by listing together in a single proposition the various interpretations of the arbitrage function we have discussed. Proposition 2 Consider a Markovian Market Weight model as in (8), and subject to the regularity assumptions of [5]. Then the relative arbitrage function U (T , z) := inf q > 0 : ∃ π(·) ∈ Π s.t. P Y q,π (T ) ≥ 1 = 1 , (T , z) ∈ (0, ∞) × Δo of (12) admits the following representations, in terms of: 1. The Cauchy problem of (20)–(21), as its smallest nonnegative classical solution; (which makes the relative 2. The probability under the Föllmer exit measure Q market weight process Z (·) a diffusion with zero drift, thus a martingale) that Z (·) has not reached the boundary of the simplex by time T , i.e., Z (t) ∈ Δo , ∀ 0 ≤ t ≤ T ; U (T , z) = Q 3. The expected log-relative-return of π (·) ≡ ν P (·), the numéraire portfolio under (· | Z (t) ∈ Δo , ∀ 0 ≤ t ≤ T ) of (27); this the probability measure P (·) := Q

16


quantity is also the maximal P -expected log-relative-return over all portfolios, to wit, for q > 0, π log 1/U (T , z) = E P log Y q, (T )/q = max EP log Y q,π (T )/q ; π(·) ∈ Π

4. The relative return of the portfolio π (·) in item 3, which is also the maximal achievable relative return over [0, T ], in the sense 1 = sup b > 0 : ∃ π(·) ∈ Π s.t. P Y q,π (T ) ≥ q b = 1 U (T , z) −1 −1 −1 −1 P = E P Λ P (T ) = E P Y q,ν (T )/q =

π (T ) Y q, , q

P-a.s.;

5. The value of the zero-sum stochastic game

Y q,π (T ) max E log P ∈ P π(·) ∈ Π q q,π (T ) Y = max min EP log , q π(·) ∈ Π P ∈ P

log 1/U (T , z) = min

P

which has the pair (P , π (·)) as saddle point in P × Π ; ) of P with respect to the Föllmer exit measure, 6. The relative entropy HT ( P | Q which is also the smallest such relative entropy attainable among probability measures in P, namely ) = min HT ( P | Q ); log 1/U (T , z) = HT ( P | Q

as well as

P∈P

T 7. The “total energy” (1/2) E P 0 ϑ P (t)2 dt expended over [0, T ] by the P induced drift ϑ P (·) as in (29) to keep the relative market weight diffusion process Z (·) in the interior of the simplex, which is also the smallest such total energy attainable among probability measures in the set P, that is, 1 P log 1/U (T , z) = E 2

0

T

ϑ

P

1 P E (t) dt = min P∈P 2

2

T

ϑ P (t)2 dt .

0

In items (3)–(5) the portfolio π (·) is given by (25), and Π denotes the class of all portfolios; whereas in item (5) the set P is the collection of all probability measures which are absolutely continuous with respect to the Föllmer exit measure on PQ F (T ) and satisfy P(Z (t) ∈ Δo , ∀ 0 ≤ t ≤ T ) = 1. Acknowledgements Work supported in part by the National Science Foundation under Grant NSF-DMS-09-05754. We are grateful to Tomoyuki Ichiba and Johannes Ruf for their comments on an early version of this work.


17

References 1. Algoet, P., Cover, T.M.: Asymptotic optimality and asymptotic equipartition property of logoptimal investment. Ann. Probab. 16, 876–898 (1988) 2. Cover, T.M., Thomas, J.A.: Elements of Information Theory, Second edn. Wiley, New York (2006) 3. Delbaen, F., Schachermayer, W.: The no-arbitrage property under a change of numéraire. Stoch. Stoch. Rep. 53, 213–226 (1995) 4. Delbaen, F., Schachermayer, W.: Arbitrage possibilities in Bessel processes and their relations to local martingales. Probab. Theory Relat. Fields 102, 357–366 (1995) 5. Fernholz, D., Karatzas, I.: On optimal arbitrage. Ann. Appl. Probab., to appear (2010) 6. Fernholz, E.R.: Stochastic Portfolio Theory. Springer, New York (2002) 7. Fernholz, E.R., Karatzas, I.: Stochastic portfolio theory: A survey. In: Bensoussan, A., Zhang, Q. (eds.) Mathematical Modeling and Numerical Methods in Finance. Handbook of Numerical Analysis, pp. 89–168. Elsevier, Amsterdam (2009) 8. Fleming, W.H.: Exit probabilities and optimal stochastic control. Appl. Math. Optim. 4, 329– 346 (1978) 9. Föllmer, H.: The exit measure of a supermartingale. Z. Wahrscheinlichkeitstheor. Verw. Geb. 21, 154–166 (1972) 10. Föllmer, H.: On the representation of semimartingales. Ann. Probab. 1, 580–589 (1973) 11. Föllmer, H.: An entropy approach to the time reversal of difusion processes. In: Lecture Notes in Control and Information Systems, vol. 69, pp. 156–163. Springer, New York (1985) 12. Föllmer, H.: Time reversal in Wiener space. In: Lecture Notes in Mathematics, vol. 1158, pp. 119–129. Springer, New York (1986) 13. Friedman, A.: Stochastic Differential Equations & Applications. Reprint of the 1975/76 edition, two volumes bound as one. Dover, New York (2006) 14. Frittelli, M.: The minimal entropy martingale measure and the valuation problem in incomplete markets. Math. Finance 10, 39–52 (2000) 15. Goia, I.: Bessel and volatility-stabilized processes. Doctoral Dissertation, Columbia University (2009) 16. Grandits, P., Rheinländer, T.: On the minimal entropy martingale measure. Ann. Probab. 30, 1003–1038 (2002) 17. Holland, C.J.: A new energy characterization of the smallest eigenvalue of the Schrödinger equation. Commun. Pure Appl. Math. 30, 755–765 (1978) 18. Karatzas, I., Kardaras, C.: The numéraire portfolio in semimartingale models. Finance Stoch. 11, 447–493 (2007) 19. Karatzas, I., Lehoczky, J.P., Shreve, S.E., Xu, G.-L.: Martingale and duality methods for utility maximization in an incomplete market. SIAM J. Control Optim. 29, 707–730 (1991) 20. Karatzas, I., Shreve, S.E.: Brownian Motion and Stochastic Calculus, Second edn. Springer, New York (1991) 21. Long Jr., J.B.: The numéraire portfolio. J. Financ. Econ. 26, 29–69 (1990) 22. Pal, S.: Analysis of market weights under volatility stabilized market models. Preprint, University of Washington, Seattle (2007) 23. Pal, S., Protter, Ph.: Strict local martingales, bubbles, and no early exercise. Preprint, Cornell University, Ithaca (2007) 24. Platen, E.A.: Benchmark approach to finance. Math. Finance 16, 131–151 (2006) 25. Ruf, J.: Optimal trading strategies under arbitrage. Preprint, Columbia University, New York (2009)

Finitely Additive Probabilities and the Fundamental Theorem of Asset Pricing Constantinos Kardaras

Abstract This work aims at a deeper understanding of the mathematical implications of the economically-sound condition of absence of arbitrages of the first kind in a financial market. In the spirit of the Fundamental Theorem of Asset Pricing (FTAP), it is shown here that the absence of arbitrages of the first kind in the market is equivalent to the existence of a finitely additive probability, weakly equivalent to the original and only locally countably additive, under which the discounted wealth processes become “local martingales”. The aforementioned result is then used to obtain an independent proof of the classical FTAP, as it appears in Delbaen and Schachermayer (Math. Ann. 300:463–520, 1994). Finally, an elementary and short treatment of the previous discussion is presented for the case of continuous-path semimartingale asset-price processes.

1 Introduction In the Quantitative Finance literature, the most common normative assumption placed on financial market models in the literature is the existence of an Equivalent Local Martingale Measure (ELMM), i.e., a probability, equivalent to the original one, that makes discounted asset-price processes local martingales. There is, of course, a very good reason for postulating the existence of an ELMM in the market: the Fundamental Theorem of Asset Pricing (FTAP) establishes1 the equivalence between a precise market viability condition, coined “No Free Lunch with Vanishing Risk” (NFLVR) with the existence of an ELMM (see [7] and [9]). C. Kardaras () Mathematics and Statistics Department, Boston University, 111 Cummington Street, Boston, MA 02215, USA e-mail: [email protected] 1 At least in the case where asset-price processes are nonnegative semimartingales; see [9] for the case of general semimartingales, where σ -martingales, a generalization of local martingales, have to be utilized. C. Chiarella, A. Novikov (eds.), Contemporary Quantitative Finance, DOI 10.1007/978-3-642-03479-4_2, © Springer-Verlag Berlin Heidelberg 2010

19

20

C. Kardaras

The importance of condition NFLVR notwithstanding, there has lately been considerable interest in researching models where an ELMM might fail to exist. Major examples include the benchmark approach in financial modeling of [24], as well as the emergence of stochastic portfolio theory [10], a descriptive theory of financial markets. Even though the previous approaches allow for the existence of some form of arbitrage, they still deal with viable models of financial markets. In fact, the markets there satisfy a weaker version of the NFLVR condition; more precisely, there is absence of arbitrages of the first kind2 (see Definition 1 of the present paper), which we abbreviate as condition NA1 . In the recent work [19], it was shown that condition NA1 is equivalent to the existence of a strictly positive local martingale deflator, i.e., a strictly positive process with the property that every asset-price, when deflated by it, becomes a local martingale. The previous mathematical counterpart of the economic NA1 condition is rather elegant; however, and in order to provide a closer comparison with the FTAP of [7], it is still natural to wish to equivalently express the NA1 condition in terms of the existence of some measure that makes discounted asset-prices have some kind of martingale property. In an effort to connect, expand, and simplify previous research, the purpose of this paper is threefold; in particular, we aim at: 1. presenting a weak version of the FTAP, stating the equivalence of the NA1 condition with the existence of a “probability” that makes discounted nonnegative wealth processes “local martingales”; 2. using the previous result as an intermediate step to obtain the FTAP as it appears in [7]; 3. providing an elementary proof of the above weak version of the FTAP discussed in (1) above when the asset-prices are continuous-path semimartingales. In order to tackle (1), we introduce the concept of a Weakly Equivalent Local Martingale Measure (WELMM). A WELMM is a finitely additive probability3 that is locally countably additive and makes discounted asset-price processes behave like local martingales. Of course, the last local martingale property has to be carefully and rigorously defined, as only finitely additive probabilities are involved—see Definition 3 later on in the text. In Theorem 1, and in a general semimartingale market model, we obtain the equivalence between condition NA1 and the existence of a WELMM. Theorem 1 can be also seen as an intermediate step in proving the FTAP of [7]. Under the validity of Theorem 1, and using the very important optional decomposition theorem, this task becomes easier, as the proof of Theorem 2 of the present paper shows. 2 The terminology “arbitrage of the first kind” was introduced in [14], although our definition, involving a limiting procedure, is closer in spirit to arbitrages of the first kind in the context of large financial markets, as appears in [15]. Here, one should also mention [22], where arbitrages of the first kind are called cheap thrills. 3 Finitely additive measures have appeared quite often in economic theory in a financial equilibrium

setting in cases of infinite horizon (see [13]) or even finite-time horizon with credit constraints on economic agents (see [22] and [23]).

Finitely Additive Probabilities and the Fundamental Theorem of Asset Pricing

21

We now come to the issue raised at (3) above. In order to establish our weak version of the FTAP, we need to invoke the main result from [19], which itself depends heavily upon results of [16]. The immense level of technicality in the proofs of the previous results render their presentation in graduate courses almost impossible. The same is true for the FTAP of [7]. Given the importance of such type of results, this is really discouraging. We provide here a partial resolution to this issue in the special case where the asset-prices are continuous-path semimartingales. As is shown in Theorem 4, proving of our main Theorem 1 becomes significantly easier; in fact, the only non-trivial result that is used in the course of the proof is the representation of a continuous-path local martingales as time-changed Brownian motion. Furthermore, in Theorem 4, condition NA1 is shown to be equivalent to the existence and square-integrability of a risk-premium process, which has nice economic interpretation and can be easily checked once the model is specified. The structure of the paper is as follows. In Sect. 2, the market is introduced, arbitrages of the first kind and the concept of a WELMM are defined, and Theorem 1, the weak version of the FTAP, is stated. Section 3 deals with a proof of the FTAP as it appears in [7]. Finally, Sect. 4 contains the statement and elementary proof of Theorem 4, which is a special case of Theorem 1 when the asset-price processes are continuous-path semimartingales.

2 Arbitrages of the First Kind and Weakly Equivalent Local Martingale Measures 2.1 General Probabilistic Remarks All stochastic processes in the sequel are defined on a filtered probability space (Ω, F , (Ft )t∈R+ , P). Here, P is a probability on (Ω, F ), where F is a σ -algebra that will make all involved random variables measurable. The filtration (Ft )t∈R+ is assumed to satisfy the usual hypotheses of right-continuity and saturation by P-null sets. A finite financial planning horizon T will be assumed. Here, T is a P-a.s. finite stopping time and all processes will be assumed to be constant, and equal to their value they have at T , after time T . It will be assumed throughout that F0 is trivial modulo P and that FT = F .

2.2 The Market and Investing Henceforth, S will be denoting the discounted, with respect to some baseline security, price process of a financial asset, satisfying: S is a nonnegative semimartingale.

(1)

22

C. Kardaras

Starting with capital x ∈ R+ , and investing according to some predictable and Sintegrable strategy ϑ , an economic agent’s discounted wealth is given by the process · ϑt dSt . (2) X x,ϑ := x + 0

In frictionless, continuous-time trading, credit constraints have to be imposed on investment in order to avoid doubling strategies. Define then X (x) to be the set of all wealth processes X x,ϑ in the notation of (2) such that X x,ϑ ≥ 0. Also, let X := x∈R+ X (x) denote the set of all nonnegative wealth processes.

2.3 Arbitrages of the First Kind The market viability notion that will be introduced now will be of central importance in our discussion. Definition 1 An FT -measurable random variable ξ will be called an arbitrage of the first kind on [0, T ] if P[ξ ≥ 0] = 1, P[ξ > 0] > 0, and for all x > 0 there exists X ∈ X (x), which may depend on x, such that P[XT ≥ ξ ] = 1. If there are no arbitrages of the first kind in the market, we say that condition NA1 holds. In view of Proposition 3.6 from [7], condition NA1 is weaker than condition NFLVR. In fact, condition NA1 is exactly the same as condition “No Unbounded Profit with Bounded Risk” (NUPBR) of [16], as we now show. Proposition 1 Condition NA1 is equivalent to the requirement that the set of terminal outcomes starting from unit wealth {XT | X ∈ X (1)} is bounded in probability. Proof Using the fact that X (x) = xX (1) for all x > 0, it is straightforward to check that if an arbitrage of the first kind exists, then {XT | X ∈ X (1)} is not bounded in probability. Conversely, assume that {XT | X ∈ X (1)} is not bounded in probability. Since {XT | X ∈ X (1)} is further convex, Lemma 2.3 of [4] implies the existence of Ωu ∈ FT with P[Ωu ] > 0 such that, for all n ∈ N, there n ≤ n} ∩ Ωu ] ≤ P[Ωu ]/2n+1 . For all n ∈ N, let n ∈ X (1) with P[{X exists X T n n A = I{ X n >n} ∩ Ωu ∈ FT . Then, set A := n∈N A ∈ FT and ξ := IA . It is clear T that ξ is FT -measurable and that P[ξ ≥ 0] = 1. Furthermore, since A ⊆ Ωu and

n T ≤ n} ∩ Ωu P Ωu \ A = P Ωu \ An ≤ P Ωu \ An = P {X n∈N

n∈N

≤

P[Ωu ]

n∈N

2n+1

n∈N

P[Ωu ] , = 2

n , and obwe obtain P[A] > 0, i.e., P[ξ > 0] > 0. For all n ∈ N set X n := (1/n)X serve that X n ∈ X (1/n) and ξ = IA ≤ IAn ≤ XTn hold for all n ∈ N. It follows that ξ is and arbitrage of the first kind, which finishes the proof.


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2.4 Weakly Equivalent Local Martingale Measures The mathematical counterpart of the economical NA1 condition involves a weakening of the concept of an ELMM. The appropriate notion turns out to involve measures that behave like probabilities, but are finitely additive and only locally countably additive. In what follows, a localizing sequence will refer to a nondecreasing sequence (τ n )n∈N of stopping times such that ↑ limn→∞ P[τ n ≥ T ] = 1. 2.4.1 Local Probabilities Weakly Equivalent to P The concept that will be introduced below in Definition 2 is essentially a localization of countably additive probabilities. Definition 2 A mapping Q : F → [0, 1] is a local probability weakly equivalent to P if: 1. Q[∅] = 0, Q[Ω] = 1, and Q is (finitely) additive: Q[A ∪ B] = Q[A] + Q[B] whenever A ∈ F and B ∈ F satisfy A ∩ B = ∅; 2. for A ∈ F , P[A] = 0 implies Q[A] = 0; 3. there exists a localizing sequence (τn )n∈N such that, when restricted on Fτn , Q is countably additive and equivalent to P, for all n ∈ N. (Such sequence of stopping times will be called a localizing sequence for Q.) Conditions (1) and (2) above imply that Q is a positive element of the dual of L∞ , the space of (equivalence classes modulo P of) F -measurable random variable that are bounded modulo P equipped with the essential-sup norm. The theory of finitely additive measures is developed in great detail in [3]; for our purposes here, mostly results from the Appendix of [6], as well as some material from [18], will be needed. To facilitate the understanding, finitely additive positive measures that are not necessarily countably additive will be denoted using sans-serif typeface (like “Q”), while for countably additive probabilities the blackboard bold typeface (like “Q”) will be used. As Q will be in the dual of L∞ , Q, ξ will denote the action of Q on ξ ∈ L∞ . The fact that Q is a positive functional enables to extend the definition of Q, ξ for ξ ∈ L0 with P[ξ ≥ 0] = 1, via Q, ξ := limn→∞ Q, ξ I{ξ ≤n} ∈ [0, ∞]. (L0 denotes the set of all P-a.s. finitely-valued random variables modulo P-equivalence equipped with the topology of convergence in probability.) Remark 1 In general, a finitely additive probability Q : F → [0, 1] is called weakly absolutely continuous with respect to P if for each A ∈ F with P[A] = 0 we have Q[A] = 0. Furthermore, Q is called strongly absolutely continuous with respect to P if for any ε > 0 there exists δ = δ(ε) > 0 such that E ∈ F and P[E] < δ implies Q[E] < ε. It is clear that strong absolute continuity of Q with respect to P is a stronger requirement than weak absolutely continuity of Q with respect to P.

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Actually, the two notions coincide when Q is countable additive. Of course, similar definitions can be made with the roles of P and Q reversed. Then, P and Q are called weakly (respectively, strongly) equivalent if Q is weakly (respectively, strongly) absolutely continuous with respect to P and P is weakly (respectively, strongly) absolutely continuous with respect to Q. In Definition 2, Q we called a local probability “weakly equivalent to P”; however, condition (2) only implies that Q is weakly absolutely continuous with respect to P. We claim that P is also weakly absolutely continuous with respect to Q. Indeed, let Q satisfy (1) and (3) of Definition 2. Pick any A ∈ F with Q[A] = 0. Since A ∩ {τn ≥ T } ∈ Fτn for all n ∈ N, Q[A ∩ {τn ≥ T }] = 0 implies that P[A ∩ {τn ≥ T }] = 0 by (3). Then, P[A] = ↑ limn→∞ P[A ∩ {τn ≥ T }] = 0. Let Q be a local probability weakly equivalent to P. When Q is only finitely, but not countably, additive, P and Q are not strongly equivalent, as we now explain. Write Q = Qr + Qs for the unique decomposition of Q in its regular and singular part. (The regular part Qr is countably additive, while the singular part Qs is purely finitely additive, meaning that there is no nonzero countably additive measure that is dominated by Qs . One can check [3] for more information.) According to Lemma A.1 in [6], for all ε > 0 one can find a set Aε ∈ F with P[Aε ] < ε and Qs [Aε ] = Qs [Ω]; therefore Q[Aε ] ≥ Qs [Ω]. In other words, if Qs is nontrivial, then Q is not strongly absolutely continuous with respect to P. Note, however, that P is strongly absolutely continuous with respect to Q in view of condition (3) of Definition 2. We briefly digress from our main topic to give a simple criterion that connects the countable additivity of Q, a local probability weakly equivalent to P, with the strong equivalence between Q and P, as the latter notion was introduced in Remark 1 above. Proposition 2 Let Q be a local probability weakly equivalent to P. The following are equivalent: 1. 2. 3. 4.

Q is countably additive, i.e., a true probability. Q is strongly absolutely continuous with respect to P. ↑ limn→∞ Q[τ n ≥ T ] = 1 holds for any localizing sequence (τ n )n∈N for Q. ↑ limn→∞ Q[τ n ≥ T ] = 1 holds for some localizing sequence (τ n )n∈N for Q.

Proof The implications (1) ⇒ (2) ⇒ (3) ⇒ (4) are straightforward, so we only focus on the implication (4) Let (E k )k∈N be a decreasing sequence of F ⇒ (1). k measurable sets such that k∈N E = ∅. We need show that ↓ limk→∞ Q[E k ] = 0. Consider the Q-localizing sequence (τ n )n∈N of statement (4). For each n ∈ N and k ∈ N we have E k ∩ {τ n ≥ T } ∈ Fτ n . (Here, remember that F = FT .) This means that lim supk→∞ Q[E k ] ≤ Q[τ n < T ] + lim supk→∞ Q[E k ∩ {τ n ≥ T }] = Q[τ n < T ], the last equality holding because Q is countably additive on Fτ n , for all n ∈ N. Sending n to infinity and using (4) we get the result.


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2.4.2 Density Processes For a local probability weakly equivalent to P as in Definition 2, one can associate a strictly positive local P-martingale Y Q , as will be now described. For all n ∈ N, consider the P-martingale Y Q, n defined by setting Q, n Y∞ ≡ YTQ, n :=

d(Q|Fτn ) . d(P|Fτn )

It is clear that, P-a.s., Y0Q, n = 1 and YTQ, n > 0. Furthermore, for all n ∈ N \ {0}, Y Q, n = Y Q, n−1 on the stochastic interval [[0, τn−1 ]]. Therefore, patching the processes (Y Q, n )n∈N together, one can define a local P-martingale Y Q such that, P-a.s., Y0Q = 1 and YTQ > 0. Remark 2 A general result in [18] shows that a supermartingale Y Q can be associated to a finitely additive measure Q that satisfies (1) and (2) of Definition 2, but not necessarily (3). The construction of Y Q in [18] is messier than the one provided above, exactly because condition (3) of Definition 2 is not assumed to hold. In the special case described here, the two constructions coincide. A partial converse of the above construction is also possible. To wit, start with some local P-martingale Y such that, P-a.s., Y0 = 1 and YT > 0. If (τn )n∈N is a localizing sequence for Y , one can define for each n ∈ N a probability Qn , equivalent to P on F , via the recipe dQn := Yτn dP. By Alaoglu’s Theorem (see, for example, Theorem 6.25, page 250 of [1]), the sequence (Qn )n∈N has some cluster point Q for the weak* topology on the dual of L∞ , which will be a finitely-additive probability. Proposition A.1 of [6] gives that dQr / dP = YT . It is easy to see that Q is a local probability weakly equivalent to P, as well as that Y Q = Y . (Note that, again by Proposition A.1 of [6], the sequence (Qn )n∈N might have several cluster points, but all will have the same regular part. Therefore, Q is not uniquely defined, but it is always the case that Y Q = Y .)

2.4.3 Local Martingales When Q is a local probability weakly equivalent to P and fails to be countably additive, the concept of a Q-martingale, and therefore also of a local Q-martingale, is tricky to state. The reason is that existence of conditional expectations requires Q to be countably additive in order to invoke the Radon-Nikodým Theorem. To overcome this difficulty, we follow an alternative route. Let Q be a probability measure, equivalent to P. According to the optional sampling theorem (see, for example, Sect. 1.3.C in [17]), a càdlàg process X is a local Q-martingale if and only if there exists a localizing sequence (τn )n∈N such that Q, Xτ n ∧τ = X0 for all n ∈ N and all stopping times τ . This characterization makes the following Definition 3 plausible.

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Definition 3 Let Q be a local probability weakly equivalent to P. A nonnegative càdlàg process X will be called a local Q-martingale if there exists a localizing sequence (τn )n∈N such that Q, Xτ n ∧τ = X0 for all n ∈ N and all stopping times τ . Now, a characterization of local Q-martingales in terms of density processes will be given. This extends the analogous result in the case where Q is countably additive. Proposition 3 Let Q be a local probability weakly equivalent to P and let Y Q be defined as in Sect. 2.4.2. A nonnegative process X is a local Q-martingale if and only if Y Q X is a local P-martingale. Proof Start by assuming that X is a local Q-martingale. Since Q, Xτ n ∧τ = X0 for all n ∈ N and all stopping times τ , where (τn )n∈N is a localizing sequence, (τn )n∈N can be assumed to also localize Q. Then, since Xτ n ∧τ ∈ Fτ n for all n ∈ N and all stopping times τ , and since Qn := Q|Fτ n is countably additive with dQn /( dP|Fτ n ) = YτQn , it follows that Y0Q X0 = X0 = Q, Xτ n ∧τ = E[YτQn Xτ n ∧τ ] = E[E[YτQn | Fτ n ∧τ ]Xτ n ∧τ ] = E[YτQn ∧τ Xτ n ∧τ ] for all n ∈ N and all stopping times τ . This means that Y Q X is a local P-martingale. Conversely, suppose that Y Q X is a local P-martingale. Let (τn )n∈N be a localizing sequence for both Y Q X and Q. Then, for all n ∈ N and all stopping times τ , X0 = Y0Q X0 = E[YτQn ∧τ Xτ n ∧τ ] = E[E[YτQn | Fτ n ∧τ ]Xτ n ∧τ ] = E[YτQn Xτ n ∧τ ] = Q, Xτ n ∧τ . Therefore, X is a local Q-martingale.

2.4.4 Weakly Equivalent Local Martingale Measures As will be shown in Theorem 1, the following definition gives the mathematical counterpart of the market viability condition NA1 . Definition 4 A weakly equivalent local martingale measure (WELMM) Q is a local probability weakly equivalent to P such that S is a local Q-martingale. Remark 3 (On the semimartingale property of S) Under the assumption that S is nonnegative, the existence of a WELMM enforces the semimartingale property on S. Indeed, write S = (1/Y Q )(Y Q S), where Q is a WELMM and Y Q is the density defined in Sect. 2.4.2. Since Y Q is a local P-martingale with YTQ > 0, P-a.s., and Y Q S is also a local P-martingale, both 1/Y Q and Y Q S are semimartingales, which gives that S is a semimartingale.


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Semimartingales are essential in frictionless financial modeling. This has been made clear in Theorem 7.1 of [7], where it was shown that if S is locally bounded and not a semimartingale, condition NFLVR using only simple trading strategies fails. Furthermore, from the treatment in [20] it follows that, if S is nonnegative and not a semimartingale, one can construct an arbitrage of the first kind, even if one uses only no-short-sale and simple strategies. If S satisfies (1), it is straightforward to check that a probability Q equivalent to P is an ELMM if and only if each X ∈ X is a local Q-martingale. The following result extends the last equivalence in the case of a WELMM. Proposition 4 Let Q be a local probability weakly equivalent to P. If S satisfies (1), then S is a local Q-martingale if and only if every process X ∈ X is a local Q-martingale. Proof Start by assuming that S is a local Q-martingale. For x ∈ R+ , let X x,ϑ in the notation of (2) be a wealth process in X (x). A use of the integration-by-parts formula gives · · x,ϑ Q x,ϑ Q Xt− − ϑt St− dYt + ϑt d(Y Q S)t . Y X =x+ 0

0

It follows that Y Q X x,ϑ is a positive martingale transform under P, and therefore a local P-martingale by the Ansel-Stricker Theorem (see [2]). Now, assume that every process in X is a local Q-martingale. Since S ∈ X , S is a local Q-martingale. Remark 4 Let Q be a local probability weakly equivalent to P. Proposition 3 combined with Proposition 4 imply that Q is a WELMM if and only if Y Q X is a local P-martingale for all X ∈ X . In other words, the process Y Q is a strict martingale density in the terminology of [25].

2.5 The Main Result After the preparation of the previous sections, it is possible to state Theorem 1 below, which can be seen as a weak version of the FTAP in [7]. Theorem 1 Suppose that S satisfies (1). Then, there are no arbitrages of the first kind in the market if and only if a weakly equivalent local martingale measure exists. Proof By Theorem 1.1 in [19], condition NA1 is equivalent to the existence of a nonnegative càdlàg process Y with Y0 = 1, YT > 0, and such that Y X is a local P-martingale for all X ∈ X . Then, using also the discussion in Sect. 2.4.2 and Proposition 3, NA1 holds if and only if there exists a local probability Q, weakly equivalent to P, such that X is a local Q-martingale for all X ∈ X . Proposition 4 gives that Q is a WELMM, which completes the proof.

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Remark 5 If the statement of the FTAP of [9] is assumed, one can provide a proof of Theorem 1 using the “change of numéraire” technique of [8]; a similar approach has been taken up in [5]. We opt here to prove Theorem 1 directly, using the result of [19] that is not relying on previous heavy results. Then, the classical FTAP itself becomes a corollary, as we shall see in Sect. 3 below. There is no claim that the path followed here is shorter or less arduous than the one taken up in [9], but certainly it has different focus. Remark 6 As can be seen from its proof, Theorem 1 still holds if the nonnegativity assumption on S is removed, as long as we agree to reformulate the notion of a WELMM Q, asking that each X ∈ X is a local Q-martingale. Furthermore, Theorem 1 holds without the assumption that S is one-dimensional. Indeed, in Remark 5 above it was discussed that Theorem 1 can be seen as a consequence of the FTAP in [9], which does not require S to be one-dimensional. Unfortunately, in [19] the assumption that S is one-dimensional is being made, mostly in order to avoid immense technical difficulties in the proof of Theorem 1.1 there, which is used to prove Theorem 1 above. Remark 7 Undoubtedly, the notion of a WELMM is more complicated than that of an ELMM. However, checking the existence of a WELMM is fundamentally easier than checking whether an ELMM exists for the market. Indeed, in view of Theorem 1, existence of a WELMM is equivalent to the existence of the numéraire portfolio in the market. For checking the existence of the latter, there exists a necessary and sufficient criterion in terms of the predictable characteristics of the discounted asset-price process, as was shown in [16]. The details are rather technical, but if the asset-price process has continuous paths the situation is very simple, as will be discussed in Sect. 4 later.

3 The FTAP of Delbaen and Schachermayer In this subsection, a proof of the FTAP as appears in [7] is given using the alreadydeveloped tools. Also, the Q-supermartingale property of wealth processes in X when Q is a WELMM is examined, and it is shown that the latter property holds only under the existence of an ELMM.

3.1 Proving the FTAP In the notation of the present paper, the main technical difficulty for proving the FTAP in [7] is showing that the set {g ∈ L0 | 0 ≤ g ≤ XT for some X ∈ X (1)} is closed in probability under the NFLVR condition. This implies the weak* closedness of the set of bounded superhedgeable claims starting from zero capital and


29

therefore allows for the use of the Kreps-Yan separation theorem (see [21] and [26]) in order to conclude the existence of a separating measure. There is a way to establish the aforementioned closedness in probability using Theorem 1 and some additional well-known results. In fact, a seemingly stronger statement than the one in [7] will now be stated and proved. Theorem 2 If no arbitrages of the first kind are present in the market, the set {g ∈ L0 | 0 ≤ g ≤ XT for some X ∈ X (1)} is closed in probability. Proof Define V ↓ (1) to be the class of nonnegative, adapted, càdlàg, nonincreasing processes with V0 ≤ 1. Then, set4 X ×× (1) := X (1) V ↓ (1) = {XV | X ∈ X (1) and V ∈ V ↓ (1)}. The statement of the Theorem can be reformulated to say that the convex set {ξT | ξ ∈ X ×× (1)} is closed in L0 . Consider therefore a sequence (ξ n )n∈N such that L0 - limn→∞ ξTn = ζ . It will be shown below that there exists ξ ∞ ∈ X ×× (1) such that ξT∞ = ζ . In what follows in the proof, the concept of Fatou-convergence is used, which will now be recalled. Define D := {k/2m | k ∈ N, m ∈ N} to be the set of dyadic rational numbers in R+ . A sequence (Z n )n∈N of nonnegative càdlàg processes Fatouconverges to Z ∞ if Zt∞ = lim sup lim sup Zsn = lim inf lim inf Zsn Ds↓t

n→∞

Ds↓t

n→∞

holds P-a.s. for all t ∈ R+ . Note that, since all processes are assumed to be constant after time T , for any t ≥ T the above relationship simply reads ZT∞ = limn→∞ ZTn , P-a.s. From Theorem 1 and Proposition 3, under absence of arbitrages of the first kind in the market, there exists some nonnegative process Y with Y 0 = 1 and Y T > 0, P-a.s., such that Y X is a local P-martingale for all X ∈ X (1). Then, Y ξ is a nonnegative P-supermartingale for all ξ ∈ X ×× (1). Since (Y ξ n )n∈N is a sequence of nonnegative P-supermartingales with Y 0 ξ0n ≤ 1, Lemma 5.2(1) of [12] n n gives the existence of a sequence (ξ )n∈N such that ξ is a convex combination n of ξ n , ξ n+1 , . . ., for each n ∈ N (and, therefore, ξ ∈ X ×× (1) for all n ∈ N, since n X ×× (1) is convex), and such that (Y ξ )n∈N Fatou-converges to some nonnegative P-supermartingale Z. Obviously, Z0 ≤ 1. Also, since L0 - limn→∞ (Y T ξTn ) = Y T ζ , n one gets ZT = Y T ζ . Define ξ ∞ := Z/Y . Then, (ξ )n∈N Fatou-converges to ξ ∞ and ∞ ξT = ζ . The last line of business is to show that ξ ∞ ∈ X ×× (1). First of all, ξ0∞ ≤ 1 and ξ ∞ is nonnegative. Let Y (1) be the class of all nonnegative process Y with Y0 = 1, P-a.s., such that Y X is a P-supermartingale for notation “X ×× (1)” is borrowed from [27] since it is suggestive of the fact that X ×× (1) is the process-bipolar of X (1), as is defined in [27]. Note, however, that it actually remains to show that X (1) is closed in probability to actually have that bipolar relationship.

4 The

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all X ∈ X (1). Of course, for all Y ∈ Y (1) and all ξ ∈ X ×× (1), Y ξ is a Pn supermartingale. It follows that Y ξ is a nonnegative P-supermartingale for all n n ∈ N. Since, for any Y ∈ Y (1), (Y ξ )n∈N Fatou-converges to Y ξ ∞ , using Fatou’s lemma one gets that Y ξ ∞ is also a P-supermartingale for all Y ∈ Y (1). Since there exists a local P-martingale in Y ∈ Y (1) with Y T > 0, P-a.s., the optional decomposition theorem as appears in [11] implies that ξ ∞ ∈ X ×× (1).

3.2 NFLVR and the Supermartingale Property of Wealth Processes Under a WELMM We now move to another characterization of the NFLVR condition using the concept of WELMMs. We start with a simple observation. If Q is a probability measure equivalent to P, it is straightforward to check that all X ∈ X are Q-supermartingales if and only if Q, XT ≤ X0 for all X ∈ X . Consider now an ELMM Q. Since nonnegative local Q-martingales are Q-supermartingales, every X ∈ X is a Qsupermartingale; therefore, Q, XT ≤ X0 for all X ∈ X . One wonders, does the last property hold when Q is replaced by a WELMM Q? Before we state and prove a result along the lines of the above discussion, some terminology will be introduced. A mapping Q : F → [0, 1] will be called a weakly equivalent finitely additive probability if (1) and (2) of Definition 2 hold, as well as, P-a.s., dQr / dP > 0. Obviously, a local probability weakly equivalent to P is a weakly equivalent finitely additive probability. A separating weakly equivalent finitely additive probability is a weakly equivalent finitely additive probability Q such that Q, XT ≤ X0 for all X ∈ X . We can then think of the processes X ∈ X as being Q-supermartingales. In accordance to the discussion above, the natural question that comes into mind is: when can we find a separating WELMM separating? In loose terms: can we find a WELMM Q such that all elements of X Qsupermartingales? The answer, given in Theorem 3 below, is that this only happens under the NFLVR condition. Theorem 3 The following are equivalent: 1. The market satisfies the NFLVR condition. 2. There exists an ELMM Q. 3. There exists a separating weakly equivalent finitely additive probability. Proof We prove (1) ⇒ (3), (3) ⇒ (2), and (2) ⇒ (1) below. (1) ⇒ (2). This is a consequence of [9] and the fact that nonnegative σ -martingales are local martingales—see [2]. (2) ⇒ (3). An ELMM is a separating weakly equivalent finitely additive probability. (3) ⇒ (1). In view of Proposition 3.6 of [7] and Proposition 1.3 proved previously in the present paper, condition NFLVR is equivalent to showing that (a) {XT | X ∈


31

X (1)} is bounded in probability, and (b) If P[XT ≥ X0 ] = 1 for some X ∈ X , then P[XT > X0 ] = 0. For (a), observe that r dQ XT = sup Qr , XT ≤ sup Q, XT ≤ 1; sup E dP X∈X (1) X∈X (1) X∈X (1) in particular, {( dQr / dP)XT | X ∈ X (1)} is bounded in probability. In view of the fact that P[( dQr / dP) > 0] = 1, we obtain that {XT | X ∈ X (1)} is bounded in probability as well. To show (b), note that, for any ε > 0 and X ∈ X with P[XT ≥ X0 ] = 1, we have X0 ≥ Q, XT ≥ Q, X0 IΩ + εI{XT >X0 +ε} = X0 + ε Q[XT > X0 + ε] ≥ X0 + ε Qr [XT > 1 + ε]. It follows that Qr [XT > X0 + ε] = 0; since P[( dQr / dP) > 0] = 1, this is equivalent to P[XT > X0 + ε] = 0. The latter holds for all ε > 0, so we get P[XT > X0 ] = 0, which completes the argument.

4 The Case of Continuous-Path Semimartingales In this section, we shall state and prove a result that implies Theorem 1 in the case where S is a d-dimensional continuous-path semimartingale. Note that Assumption (1) will not be in force here; in particular, there can be more than one traded security and the prices of securities do not have to be nonnegative. In fact, Theorem 4 that is presented below actually sharpens the conclusion of Theorem 1 by providing a further equivalence in terms of the local rates of return and local covariances of the discounted prices S = (S i )i=1,...,d . We first introduce some notation. Since S is a continuous-path semimartingale, one has the decomposition S = A + M, where A = (A1 , . . . , Ad ) has continuous paths and is of finite variation, and M = (M 1 , . . . , M d ) is a continuous-path local martingale. Denote by [M i , M k ] the quadratic (co)variation of M i and M k . Also, let [M, M] be the d × d nonnegative-definite symmetric matrix-valued process whose (i, k)-component is [M i , M k ]. Call now G := trace[M, M], where trace is the operator returning the trace of a matrix. Observe that G is an increasing, adapted, continuous process and that there exists a d ×d nonnegative-definite symmetric · · matrix-valued process c such that [M i , M k ] = 0 cti,k dGt ; [M, M] = 0 ct dGt in short. Theorem 4 In the continuous-semimartingale market described above, the following statements are equivalent: 1. There are no arbitrages of the first kind in the market. 2. There exists a strictly positive local P-martingale Y with Y0 = 1 such that Y S i is a local P-martingale for all i ∈ {1, . . . , d}. · 3. There exists a d-dimensional, predictable process ρ such that A = 0 (ct ρt ) dGt , T as well as 0 ρt , ct ρt dGt < ∞.

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Proof We prove (1) ⇒ (3), (3) ⇒ (2), and (2) ⇒ (1) below. (1) ⇒ (3). We shall show that if statement (3) of Theorem 4 is not valid, then {XT | X ∈ X (1)} is not bounded in probability. In view of Proposition 1, (1) ⇒ (3) will be established. Suppose that one cannot find a predictable d-dimensional process ρ such that · A = 0 (ct ρt ) dGt . In that case, linear algebra combined with a simple measurable selection argument gives the existence of some bounded predictable process T · θ such that (a) 0 θt dGt = 0, (b) 0 θt , dAt is a nondecreasing process, and (c) T P[ 0 θt , dAt > 0] > 0. This means that X 1,θ ∈ X (1), in the notation of (2), satisfies X 1,θ ≥ 1, P[XT1,θ > 1] > 0. Then, X 1,kθ ∈ X (1) for all k ∈ N and (X 1,kθ )k∈N is not bounded in probability. · Now, suppose that A = 0 (ct ρt ) dGt for some predictable d-dimensional process T ρ, but that P[ 0 ρt , ct ρt dGt = ∞] > 0. Consider the sequence π k := ρI{|ρ|≤k} and let X k be defined via X0k = 1 and satisfying dXtk = Xtk πtk dSt . Then, Itô’s formula implies that T

ETk k log XT = − + ρt I{|ρt |≤k} dMt , 2 0 T k holds for all k ∈ N, where ET := 0 ρt , ct ρt I{|ρt |≤k} dGt coincides with the total · quadratic variation of the local martingale 0 (ρt I{|ρt |≤k} ) dMt . It follows that, for every k ∈ N, one can find a one-dimensional standard Brownian motion β k such that ETk + βEk k . 2 T The strong law of large numbers for Brownian motion will imply that ⎡ k ⎤ β k T ET

ρt , ct ρt dGt = ∞⎦ = 0, for all ε > 0, lim P ⎣ k > ε, k→∞ 0 ET log XTk = −

so that lim P

k→∞

log XTk ETk

T 1

ρt , ct ρt dGt = ∞ = 1, for all ε > 0. > −ε 2 0

T Choosing ε = 1/4, it follows that if P[ 0 ρt , ct ρt dGt = ∞] > 0, the sequence (XTk )k∈N is not bounded in probability. (3) ⇒ (2). With the data of condition (3) there, define the process · 1 ·

ρt , dSt +

ρt , ct ρt dGt . Y := exp − 2 0 0 Condition (3) ensures that Y is well-defined (meaning that the two integrals above make sense). Itô’s formula easily shows that Y is a local P-martingale. Then, a


33

simple use of integration-by-parts gives that Y S i is a local martingale for all i ∈ {1, . . . , d}. (2) ⇒ (1). The proof of this implication is somewhat classic, but will be presented anyhow for completeness. Start with a sequence (X k )k∈N of wealth processes such that limk→∞ X0k = 0 as well as XTk ≥ ξ for some R+ -valued random variable ξ . Since Y S i is a local P-martingale for all i ∈ {1, . . . , d}, a straightforward multidimensional generalization of the proof of Proposition 3 shows that, for all k ∈ N, Y X k is a local P-martingale. As nonnegative local P-martingales are Psupermartingales, we have E[YT ξ ] ≤ E[YT XTk ] ≤ X0k holding for all k ∈ N. Therefore, since limk→∞ X0k = 0, we obtain E[YT ξ ] = 0. Since YT > 0 and ξ ≥ 0, P-a.s, the last inequality holds if only if P[ξ = 0] = 1. Therefore, (X k )k∈N is not an arbitrage of the first kind. Remark 8 (Market price of risk and the numéraire portfolio) Condition (3) of Theorem 4 has some economic consequences. Assume for simplicity that G is ab· solutely continuous with respect to Lebesgue measure, i.e., that G := 0 gt dt for · some predictable process g. Under condition NA1 , we also have A := 0 at dt for some predictable process g, and that there exists a predictable process ρ such that cρ = a. (In fact, the latter process ρ can be taken to be equal to c† a, where c† is the Moore-Penrose pseudo-inverse of c.) Now, take c1/2 to be any root of the nonnegative-definite matrix c (that can be chosen in a predictable way) and define √ σ := c1/2 g. Then, we can write dSt = σt (λt dt + dWt ), where W is a standard d-dimensional Brownian motion5 and λ := σ ρ is a risk premium process (in the one-dimensional case also commonly known as the Sharpe ratio), that has to satisfy T 2 0 |λt | dt < ∞ for all T ∈ R+ . We conclude that condition NA1 is valid if and only if a risk-premium process exists and is locally square-integrable in a pathwise sense.

References 1. Aliprantis, C.D., Border, K.C.: Infinite-Dimensional Analysis – A Hitchhiker’s Guide, Second edn. Springer, Berlin (1999) 2. Ansel, J.-P., Stricker, C.: Couverture des actifs contingents et prix maximum. Ann. Inst. Henri Poincaré Probab. Stat. 30, 303–315 (1994) 3. Bhaskara Rao, K.P.S., Bhaskara Rao, M.: Theory of Charges: A Study of Finitely Additive Measures. Pure and Applied Mathematics, vol. 109. Academic Press Inc. [Harcourt Brace Jovanovich Publishers], New York, With a foreword by D.M. Stone (1983) 4. Brannath, W., Schachermayer, W.: A bipolar theorem for L0+ (Ω, F , P). In: Séminaire de Probabilités, XXXIII. Lecture Notes in Math., vol. 1709, pp. 349–354. Springer, Berlin (1999) the case where c is nonsingular for Lebesgue-almost every t ∈ R, P-almost surely, we have · −1/2 dMt . If c fails to be nonsingular for Lebesgue-almost every t ∈ R, P-almost surely, 0 ct · 1/2 one can still construct a Brownian motion W in order to have M· = 0 ct dWt holding by enlarging the probability space—check for example [17], Theorem 4.2 of Sect. 3.4. 5 In

W· :=

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5. Christensen, M.M., Larsen, K.: No arbitrage and the growth optimal portfolio. Stoch. Anal. Appl. 25, 255–280 (2007) 6. Cvitanić, J., Schachermayer, W., Wang, H.: Utility maximization in incomplete markets with random endowment. Finance Stoch. 5, 259–272 (2001) 7. Delbaen, F., Schachermayer, W.: A general version of the fundamental theorem of asset pricing. Math. Ann. 300, 463–520 (1994) 8. Delbaen, F., Schachermayer, W.: The no-arbitrage property under a change of numéraire. Stoch. Stoch. Rep. 53, 213–226 (1995) 9. Delbaen, F., Schachermayer, W.: The fundamental theorem of asset pricing for unbounded stochastic processes. Math. Ann. 312, 215–250 (1998) 10. Fernholz, E., Karatzas, I.: Stochastic Portfolio Theory: An Overview. Handbook of Numerical Analysis, vol. 15, pp. 89–167 (2009) 11. Föllmer, H., Kabanov, Y.M.: Optional decomposition and Lagrange multipliers. Finance Stoch. 2, 69–81 (1998) 12. Föllmer, H., Kramkov, D.: Optional decompositions under constraints. Probab. Theory Relat. Fields 109, 1–25 (1997) 13. Gilles, C., LeRoy, S.F.: Bubbles and charges. Int. Econ. Rev. 33, 323–339 (1992) 14. Ingersoll, J.E.: Theory of Financial Decision Making. Rowman and Littlefield Studies in Financial Economics. Rowman & Littlefield, Totowa (1987) 15. Kabanov, Y.M., Kramkov, D.O.: Large financial markets: asymptotic arbitrage and contiguity. Teor. Veroyatn. I Primenen. 39, 222–229 (1994) 16. Karatzas, I., Kardaras, C.: The numéraire portfolio in semimartingale financial models. Finance Stoch. 11, 447–493 (2007) 17. Karatzas, I., Shreve, S.E.: Brownian Motion and Stochastic Calculus. Graduate Texts in Mathematics, vol. 113, Second edn. Springer, New York (1991) 18. Karatzas, I., Žitković, G.: Optimal consumption from investment and random endowment in incomplete semimartingale markets. Ann. Probab. 31, 1821–1858 (2003) 19. Kardaras, C.: Market viability via absence of arbitrages of the first kind. Submitted for publication. Preprint available at http://arxiv.org/abs/0904.1798 (2009) 20. Kardaras, C., Platen, E.: On the semimartingale property of discounted asset-price processes. Submitted for publication. Preprint available at http://arxiv.org/abs/0803.1890 (2008) 21. Kreps, D.M.: Arbitrage and equilibrium in economies with infinitely many commodities. J. Math. Econ. 8, 15–35 (1981) 22. Loewenstein, M., Willard, G.A.: Local martingales, arbitrage, and viability. Free snacks and cheap thrills. Econom. Theory 16, 135–161 (2000) 23. Loewenstein, M., Willard, G.A.: Rational equilibrium asset-pricing bubbles in continuous trading models. J. Econ. Theory 91, 17–58 (2000) 24. Platen, E., Heath, D.: A Benchmark Approach to Quantitative Finance. Springer Finance. Springer, Berlin (2006) 25. Schweizer, M.: On the minimal martingale measure and the Föllmer-Schweizer decomposition. Stoch. Anal. Appl. 13, 573–599 (1995) 26. Yan, J.A.: Caractérisation d’une classe d’ensembles convexes de L1 ou H 1 . Seminar on Probability XIV. Lecture Notes in Math., vol. 784 pp. 220–222. Springer Berlin (1980) 27. Žitković, G.: A filtered version of the bipolar theorem of Brannath and Schachermayer. J. Theor. Probab. 15, 41–61 (2002)

M6 —On Minimal Market Models and Minimal Martingale Measures Hardy Hulley and Martin Schweizer

Abstract The well-known absence-of-arbitrage condition NFLVR from the fundamental theorem of asset pricing splits into two conditions, called NA and NUPBR. We give a literature overview of several equivalent reformulations of NUPBR; these include existence of a growth-optimal portfolio, existence of the numeraire portfolio, and for continuous asset prices the structure condition (SC). As a consequence, the minimal market model of E. Platen is seen to be directly linked to the minimal martingale measure. We then show that reciprocals of stochastic exponentials of continuous local martingales are time changes of a squared Bessel process of dimension 4. This directly gives a very specific probabilistic structure for minimal market models.

1 Introduction Classical mathematical finance has been built on pillars of absence of arbitrage; this is epitomised by the celebrated fundamental theorem of asset pricing (FTAP), due in its most general form to F. Delbaen and W. Schachermayer. However, several recent directions of research have brought up the question whether one should not also study more general models that do not satisfy all the stringent requirements of the FTAP; see also [21] for an early contribution in that spirit. One such line of research is the recent work of R. Fernholz and I. Karatzas on diverse markets,

This paper is dedicated to Eckhard Platen on the occasion of his 60th birthday. H. Hulley School of Finance and Economics, University of Technology, Sydney, P.O. Box 123, Broadway, NSW 2007, Australia e-mail: [email protected] M. Schweizer () Departement Mathematik, ETH-Zentrum, ETH Zürich, HG G 51.2, CH–8092 Zürich, Switzerland e-mail: [email protected] C. Chiarella, A. Novikov (eds.), Contemporary Quantitative Finance, DOI 10.1007/978-3-642-03479-4_3, © Springer-Verlag Berlin Heidelberg 2010

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H. Hulley and M. Schweizer

of which an overview is given in [17]. Another is the benchmark approach and the idea of minimal market models proposed and propagated by E. Platen and coauthors in several recent publications; see [24] for a textbook account. Finally, also some approaches to bubbles go in a similar direction. Our goal in this paper is twofold. We first give a neutral overview of several equivalent formulations of an L0 -boundedness property, called NUPBR, that makes up a part, but not all of the conditions for the FTAP. For continuous asset prices, we then show that the minimal market model of E. Platen is very directly linked to the minimal martingale measure introduced by H. Föllmer and M. Schweizer. As a consequence, we exhibit a very specific probabilistic structure for minimal market models: We show that they are time changes of a squared Bessel process of dimension 4 (a BESQ 4 ), under very weak assumptions. This extends earlier work in [22] to the most general case of a continuous (semimartingale) financial market. The paper is structured as follows. Section 2 considers general semimartingale models, introduces basic notations, and recalls that the well-known condition NFLVR underlying the FTAP consists of two parts: no arbitrage NA, and a certain boundedness condition in L0 , made more prominent through its recent labelling as NUPBR by C. Kardaras and co-authors. We collect from the literature several equivalent formulations of this property, the most important for subsequent purposes being the existence of a growth-optimal portfolio. Section 3 continues this overview under the additional assumption that the basic price process S is continuous; the main addition is that NUPBR is then also equivalent to the structure condition (SC) introduced by M. Schweizer, and that it entails the existence of the minimal martingale density for S. Both Sects. 2 and 3 contain only known results from the literature; their main contribution is the effort made to present these results in a clear, concise and comprehensive form. The main probabilistic result in Sect. 4 shows that reciprocals of stochastic exponentials of continuous local martingales are automatically time changes of BESQ4 processes. Combining this with Sect. 3 then immediately yields the above announced structural result for minimal market models.

2 General Financial Market Models This section introduces basic notations and concepts and recalls a number of general known results. Loosely speaking, the main goal is to present an overview of the relations between absence of arbitrage and existence of a log-optimal portfolio strategy, in a frictionless financial market where asset prices can be general semimartingales. The only potential novelty in all of this section is that the presentation is hopefully clear and concise. We deliberately only give references to the literature instead of repeating proofs, in order not to clutter up the presentation. We start with a probability space (Ω, F , P ) and a filtration F = (Ft )0≤t≤T satisfying the usual conditions of right-continuity and P -completeness. To keep notations simple, we assume that the time horizon T ∈ (0, ∞) is nonrandom and finite. All our basic processes will be defined on [0, T ] which frees us from worrying about

On Minimal Market Models and Minimal Martingale Measures

37

their behaviour at “infinity” or “the end of time”. Results from the literature on processes living on [0, ∞) are used by applying them to the relevant processes stopped at T . We consider a financial market with d + 1 assets. One of these is chosen as numeraire or unit of account, labelled with the number 0, and all subsequent quantities are expressed in terms of that. So we have an asset S 0 ≡ 1 and d “risky” assets whose price evolution is modelled by an Rd -valued semimartingale S = (St )0≤t≤T , where Sti is the price at time t of asset i ∈ {1, . . . , d}, expressed in units of asset 0. To be able to use stochastic integration, we assume that S is a semimartingale. Trading in our financial market is frictionless and must be done in a self-financing way. Strategies are then described by pairs (x, ϑ), where x ∈ R is the initial capital or initial wealth at time 0 and ϑ = (ϑt )0≤t≤T is an Rd -valued predictable S-integrable process; we write ϑ ∈ L(S) for short. The latter means that the (realvalued) stochastic integral process ϑ . S := ϑ dS is well defined and then again a semimartingale. We remark in passing that ϑ . S must be understood as a vector stochastic integral, which may be different from the sum of the componentwise stochastic integrals; see [14] for the general theory and [4] for an amplification of the latter point. In financial terms, ϑti is the number of units of asset i that we hold in our dynamically varying portfolio at time t, and the self-financing condition means that our wealth at time t is given by t ϑu dSu , 0 ≤ t ≤ T . Xtx,ϑ := x + ϑ . St = x + 0

Not every ϑ ∈ L(S) yields a decent trading strategy. To exclude unpleasant phenomena resulting from doubling-type strategies, one has to impose some lower bound on the trading gains/losses ϑ . S. We call ϑ ∈ L(S) a-admissible if ϑ . S ≥ −a, where a ≥ 0, and admissible if it is a-admissible for some a ≥ 0. We then introduce for x > 0 the sets X x := X x,ϑ ϑ ∈ L(S) and X x,ϑ ≥ 0 = {x + ϑ . S | ϑ ∈ L(S) is x-admissible}, X x,++ := X x,ϑ ϑ ∈ L(S) and X x,ϑ > 0 as well as X x,ϑ > 0 , −

{XTx,ϑ

XTx,++

| X x,ϑ ∈ X x }, with defined analogously. So every and we set XTx := x f ∈ XT represents a terminal wealth position that one can generate out of initial wealth x by self-financing trading while keeping current wealth always nonnegative x,ϑ (and even strictly positive, if f is in XTx,++ ). We remark that X− > 0 does not follow from X x,ϑ > 0 since we only know that X x,ϑ is a semimartingale; we have no local martingale or supermartingale property at this point. Note that all the ϑ appearing in the definition of XTx have the same uniform lower bound for ϑ . S, namely −x. Finally, we need the set C := XT0,ϑ − B ϑ ∈ L(S) is admissible, B ∈ L0+ (FT ) ∩ L∞ of all bounded time T positions that one can dominate by self-financing admissible trading even from initial wealth 0. With the above notations, we can now recall from [9] and [18] the following concepts.

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Definition Let S be a semimartingale. We say that S satisfies NA, no arbitrage, if C ∩ L∞ + = {0}; in other words, C contains no nonnegative positions except 0. We ∞ say that S satisfies NFLVR, no free lunch with vanishing risk, if C ∩ L∞ + = {0}, ∞ ∞ where C denotes the closure of C in the norm topology of L . Finally, we say that S satisfies NUPBR, no unbounded profit with bounded risk, if XTx is bounded in L0 for some x > 0 (or, equivalently, for all x > 0 or for x = 1, because XTx = xXT1 ). The condition NFLVR is a precise mathematical formulation of the natural economic idea that it should be impossible in a financial market to generate something out of nothing without risk. The meta-theorem that “absence of arbitrage is tantamount to the existence of an equivalent martingale measure” then takes the precise form that S satisfies NFLVR if and only if there exists a probability measure Q equivalent to P such that S is under Q a so-called σ -martingale. This is the celebrated fundamental theorem of asset pricing (FTAP) in the form due to F. Delbaen and W. Schachermayer; see [6, 8]. In the sequel, our interest is neither in the FTAP nor in equivalent σ -martingale measures Q as above; hence we do not explain these in more detail. Our focus is on the condition NUPBR and its ramifications. The connection to NFLVR is very simple and direct: S satisfies NFLVR if and only if it satisfies both NA and NUPBR. This result can be found either in Sect. 3 of [6] or more concisely in Lemma 2.2 of [15]. Moreover, neither of the conditions NA and NUPBR implies the other, nor of course NFLVR; see Chap. 1 of [12] for explicit counterexamples. The next definition introduces strategies with certain optimality properties. np

Definition An element X np = X 1,ϑ of X 1,++ is called a numeraire portfolio if the ratio X 1,ϑ /X np is a P -supermartingale for every X 1,ϑ ∈ X 1,++ . An element go X go = X 1,ϑ of X 1,++ is called a growth-optimal portfolio or a relatively logoptimal portfolio if go

E log XT1,ϑ /XT ≤ 0 for all X 1,ϑ ∈ X 1,++ such that the above expectation is not ∞ − ∞. Finally, an lo element X lo = X 1,ϑ of X 1,++ with E[log XTlo ] < ∞ is called a log-utility-optimal portfolio if

E log XT1,ϑ ≤ E log XTlo for all X 1,ϑ ∈ X 1,++ such that E[(log XT1,ϑ )− ] < ∞. For all the above concepts, we start with initial wealth 1 and look at self-financing strategies whose wealth processes (together with their left limits) must remain strictly positive. In all cases, we also commit a slight abuse of terminology by calling “portfolio” what is actually the wealth process of a self-financing strategy. In words, the above three concepts can then be described as follows:


39

• The numeraire portfolio has the property that, when used for discounting, it turns every wealth process in X 1,++ into a supermartingale. Loosely speaking, this means that it has the best “performance” in the class X 1,++ . • The growth-optimal portfolio has, in relative terms, a higher expected growth rate (measured on a logarithmic scale) than any other wealth process in X 1,++ . • The log-utility-optimal portfolio maximises the expected logarithmic utility of terminal wealth essentially over all wealth processes in X 1,++ . The next result gives the first main connection between the notions introduced so far. Proposition 1 1) X np , X go and X lo are all unique. 2) X np , X go and X lo coincide whenever they exist. 3) X np exists if and only if X go exists. This is also equivalent to existence of X lo if in addition sup{E[log XT ] | X ∈ X 1,++ with E[(log XT )− ] < ∞} < ∞. 4) X np (or equivalently X go ) exists if and only if S satisfies NUPBR. Proof This is a collection of well-known results; see [3, Propositions 3.3 and 3.5], [5, Theorem 4.1], and [18, Proposition 3.19 and Theorem 4.12]. Our next definition brings us closer again to equivalent σ -martingale measures for S. Definition An equivalent supermartingale deflator (for X 1,++ ) is an adapted RCLL process Y = (Yt )0≤t≤T with Y0 = 1, Y ≥ 0, YT > 0 P -a.s. and the property that Y X 1,ϑ is a P -supermartingale for all X 1,ϑ ∈ X 1,++ . The set of all equivalent supermartingale deflators is denoted by Y. Because X 1,++ contains the constant process 1, we immediately see that each Y ∈ Y is itself a supermartingale; and YT > 0 implies by the minimum principle for supermartingales that then also Y > 0 and Y− > 0. To facilitate comparisons, we mention that the class X 1,++ is called N in [3], and Y is called SM there. Definition A σ -martingale density (or local martingale density) for S is a local P -martingale Z = (Zt )0≤t≤T with Z0 = 1, Z ≥ 0 and the property that ZS i is a P -σ -martingale (or P -local martingale, respectively) for each i = 1, . . . , d. If ++ Z > 0, we call Z in addition strictly positive. For later use, we denote by Dloc (S, P ) the set of all strictly positive local P -martingale densities Z for S. From the well-known Ansel–Stricker result (see Corollaire 3.5 of [2]), it is clear that ZX 1,ϑ is a P -supermartingale for all X 1,ϑ ∈ X 1,++ whenever Z is a σ - or local martingale density for S. Hence Y contains all strictly positive σ - and local martingale densities for S. On the other hand, if Q is an equivalent σ - or local martingale measure for S (as in the FTAP, in the sense that each S i is a Q-σ -martingale or local

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Q-martingale, respectively), then the density process Z Q of Q with respect to P is by the Bayes rule a strictly positive σ - or local martingale density for S, if it has Q Z0 = 1 (which means that Q = P on F0 ). In that sense, supermartingale deflators can be viewed as a generalisation of equivalent σ - or local martingale measures for S. This important idea goes back to [20]. The second main connection between the concepts introduced in this section is provided by Proposition 2 The Rd -valued semimartingale S satisfies NUPBR if and only if there exists an equivalent supermartingale deflator for X 1,++ . In short: NUPBR ⇐⇒ Y = ∅. Proof This is part of [18, Theorem 4.12].

Combining what we have seen so far, we directly obtain the main result of this section. Theorem 3 For an Rd -valued semimartingale S, the following are equivalent: 1) 2) 3) 4)

S satisfies NUPBR. The numeraire portfolio X np exists. The growth-optimal portfolio X go exists. There exists an equivalent supermartingale deflator for X 1,++ , i.e. Y = ∅.

In each of these cases, X np and X go are unique, and X np = X go . If in addition sup{E[log XT ] | X ∈ X 1,++ with E[(log XT )− ] < ∞} < ∞, then 1)–4) are also equivalent to 5) The log-utility-optimal portfolio X lo exists. In that case, also X lo is unique, and X lo = X np = X go . Remarks 1) We emphasise once again that all these results are known. In the above most general form, they are due to [18], but variants and precursors can already be found in [3, 5, 21]. In particular, Theorem 5.1 in [5] shows that under the assumption NA, the existence of the growth-optimal portfolio X go is equivalent to the existence of a strictly positive σ -martingale density for S. 2) It seems that the key importance of the condition NUPBR, albeit not under that name and in the more specialised setting of a complete Itô process model, has first been recognised in [21], who relate NUPBR to the absence of so-called cheap thrills; see Theorem 2 in [21]. 3) If the numeraire portfolio X np exists, then it lies in X 1,++ and at the same time, 1/X np lies in Y, by the definitions of X np and Y. So another property equivalent to 1)–4) in Theorem 3 would be that X 1,++ ∩ (1/Y) = ∅ or Y ∩ (1/X 1,++ ) = ∅.


41

4) Since we work on the closed interval [0, T ], all our processes so far are defined np up to and including T . Hence we need not worry about finiteness of XT , which is in contrast to [18]. 5) In view of the link to log-utility maximisation, it is no surprise that there are also dual aspects and results for the above connections. This is for instance presented in [3] and [18], but is not our main focus here. 6) For yet another property equivalent to NUPBR, see the recent work in [19]. The third important result in this section would be a more explicit description of the numeraire portfolio X np or, more precisely, its generating strategy ϑ np . Such a description can be found in [18, Theorem 3.15], or more generally in [11, Theorem 3.1 and Corollary 3.2]. In both cases, ϑ np can be obtained (in principle) by pointwise maximisation of a function (called g or Λ, respectively, in the above references) that is given explicitly in terms of certain semimartingale characteristics. In [18], this involves the characteristics of the returns process R, where each S i = S0i E(R i ) is assumed to be a stochastic exponential. By contrast, the authors of [11] take a general semimartingale S and allow in addition to trading also consumption with a possibly stochastic clock; they then need the (joint) characteristics of (S, M), where M is a certain process defined via the stochastic clock. In the general case where S can have jumps, neither of these descriptions unfortunately gives very explicit expressions for ϑ np since the above pointwise maximiser is only defined implicitly. For this reason, we do not go into more detail here, and focus in the next section on the much simpler case where S is continuous.

3 Continuous Financial Market Models In this section, we focus on the special case when S on (Ω, F , F, P ) from Sect. 2 is continuous. We introduce some more concepts and link them to those of Sect. 2. Again, all the results given here are well known from the literature, and we at most claim credit for a hopefully clear and concise overview. So let S = (St )0≤t≤T be an Rd -valued continuous semimartingale with canonical decomposition S = S0 +M +A. The processes M = (Mt )0≤t≤T and A = (At )0≤t≤T are both Rd -valued, continuous and null at 0. Moreover, M is a local P -martingale and A is adapted and of finite variation. The bracket process M of M is the adapted, continuous, d × d-matrix-valued process with components M ij = M i , M j for i, j = 1, . . . , d; it exists because M is continuous, hence locally square-integrable. Definition We say that S satisfies the weak structure condition (SC ) if A is absod lutely continuous with respect to M in the sense that there exists an R -valued predictable process λ = ( λt )0≤t≤T such that A = d M λ, i.e. d t d t j ij j λu d M u = λu d M i , M j u for i = 1, . . . , d and 0 ≤ t ≤ T . Ait = j =1 0

j =1 0

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We then call λ the (instantaneous) market price of risk for S and sometimes informally write λ = dA/d M . Definition If S satisfies the weak structure condition (SC ), we define t d t j t := λtru d M λiu λu d M i , M j u , 0 ≤ t ≤ T λu = K 0

i,j =1 0

= (K t )0≤t≤T the mean-variance tradeoff process of S. Because M is and call K is increasing and null at 0; but note that it may positive semidefinite, the process K take the value +∞ in general. We say that S satisfies the structure condition (SC) if T < ∞ P -a.s. S satisfies (SC ) and K Remarks 1) There is some variability in the literature concerning the structure condition; some authors call (SC) what we label (SC ) here. The terminology we have chosen is consistent with [26]. For discussions of the difference between (SC ) and (SC), we refer to [7] and [16]. 2) The weak structure condition (SC ) comes up very naturally via Girsanov’s theorem. In fact, suppose S is a local Q-martingale under some Q equivalent to P and 1/Z is the density process of P with respect to Q. Then the process M := S − S0 − Z− d S, Z1 is by Girsanov’s theorem a local P -martingale null at 0 and continuous like S, and A := Z− d S, Z1 = Z− d M, Z1 is absolutely continuous with respect to M by the Kunita–Watanabe inequality. These results are of course well known from stochastic calculus; but their relevance for mathematical finance was only discovered later around the time when the importance of equivalent local martingale measures was highlighted by the FTAP. T < ∞ P -a.s. can equivalently be formuIf S satisfies (SC), the condition K lated as λ ∈ L2loc (M) (on [0, T ], to be accurate). This means that the stochastic integral process λ. M = λ dM is well defined and a real-valued continuous local = P -martingale null at 0, and we have K λ . M . The stochastic exponential

1 . . Zt := E(−λ M)t = exp −λ Mt − Kt , 0 ≤ t ≤ T 2 0 = 1. For is then also well defined and a strictly positive local P -martingale with Z is called the minimal martingale density reasons that will become clear presently, Z for S. Proposition 4 Suppose S is an Rd -valued continuous semimartingale. Then S satisfies the structure condition (SC) if and only if there exists a strictly positive local martingale density Z for S. In short: ++ (SC) ⇐⇒ Dloc (S, P ) = ∅.


43

= E(− Proof If S satisfies (SC), we have seen above that Z λ . M) is a strictly pos itive local P -martingale with Z0 = 1. Moreover, using (SC), it is a straightforward i is a local P -martingale. computation via the product rule to check that each ZS Hence we can take Z = Z. Conversely, suppose that ZS and Z > 0 are both local P -martingales. If Z is a true P -martingale on [0, T ], it can be viewed as the density process of some Q equivalent to P such that, by the Bayes rule, S is a local Q-martingale. Then the Girsanov argument in Remark 2) above gives (SC ). In general, applying the product rule shows that ZS has the finite variation part Z− dA+ Z, S , which must vanish because ZS is a local P -martingale. This gives 1 1 A=− d S, Z = − d M, Z , Z− Z− hence again (SC ), and with some more work, one shows that even (SC) is satisfied. For the details, we refer to Theorem 1 of [26]. Since S is continuous, Theorem 1 of [26] also shows, by an application of the Kunita–Watanabe decomposition with respect to M to the stochastic logarithm N of Z = E(N ), that every strictly positive local martingale density Z for S can be E(L) for some local P -martingale L null at 0 which is strongly written as Z = Z is minimal in that it is obtained for P -orthogonal to M. From that perspective, Z the simplest choice L ≡ 0. One can also exhibit other minimality properties of Z, but this is not our main focus here. is (for continuous S) always strictly positive, it is in general only Remark While Z happens to be a true P -martingale a local, but not a true P -martingale. But if Z (on [0, T ]), or equivalently if EP [ZT ] = 1, we can define a probability measure P equivalent to P via d P := ZT dP . The local P -martingale property of ZS is by the -martingale. This P , if it Bayes rule then equivalent to saying that S is a local P exists, is called the minimal martingale measure; see [10]. As we have already seen in Sect. 2, the family Y of all equivalent supermartin++ gale deflators for X 1,++ contains the family Dloc (S, P ) of all strictly positive local ++ martingale densities for S. Therefore Dloc (S, P ) = ∅ implies that Y = ∅, and this already provides a strong first link between the results in this section and those in Sect. 2. A second link is given by the following connection between the minimal and the numeraire portfolio X np . martingale density Z Lemma 5 Suppose S is an Rd -valued continuous semimartingale. If S satisfies (SC), then X np exists and is given by X np = 1/Z. = E(− Proof Since S satisfies (SC), Z λ . M) exists and

1 1 = exp 1/Z λ. M + K = exp λ. S − K = E( λ . S), 2 2

44


ϑ lies in X 1,++ = X 1, because S = S0 + M + d M λ. This shows that 1/Z with ϑ = λ/Z. Moreover, ZS is a local P -martingale by (the proof of) Proposition 4. A straightforward application of the product rule then shows that also 1,ϑ is a local P -martingale, for every X 1,ϑ ∈ X 1,++ , and so this product is also a ZX satisfies the requirements for P -supermartingale since it is nonnegative. Thus 1/Z the numeraire portfolio and therefore agrees with X np by uniqueness. Of course, also Lemma 5 is not really new; the result can essentially already be found in [3, Corollary 4.10]. If one admits that the numeraire portfolio X np coincides with the growth-optimal portfolio X go , one can also quote [5, Corollary 7.4]. And finally, one could even use the description of X np in [18, Theorem 3.15], because this becomes explicit when S is continuous. For a complete and detailed connection between Sects. 2 and 3, the next result provides the last link in the chain. In the present formulation, it seems due to [12, Theorem 1.25]; the proof we give here is perhaps a little bit more compact. Proposition 6 Suppose S is an Rd -valued continuous semimartingale. If the numeraire portfolio X np exists, then S satisfies the structure condition (SC). Proof For every X 1,ϑ ∈ X 1,++ , we can write X 1,ϑ = E(π . S) with π := ϑ/X 1,ϑ . Moreover, both ϑ and π are S-integrable and hence also in L2loc (M), since the processes X 1,ϑ > 0, S and M are all continuous. Using the explicit expression E(π . S) = exp(π . S − 12 π tr d M π) for the stochastic exponential then gives for every X 1,ϑ ∈ X 1,++ that X 1,ϑ E(π . S) = np X E(π np . S)

1 1 np . tr np tr np = exp (π − π ) S − π d M π + (π ) d M π 2 2

1 np . np tr np = exp (π − π ) M − (π − π ) d M (π − π ) 2

np tr np , × exp (π − π ) dA − d M π where the last equality is readily verified by multiplying out and collecting terms. But this means that X 1,ϑ = E(L) exp(B), (1) X np where L := (π − π np ) . M (and hence also E(L)) is a continuous local P -martingale and B := B(π) := (π − π np )tr dA − d M π np is a continuous adapted process of finite variation. Because X np is the numeraire portfolio, the left-hand side of (1) is a P -supermartingale for every ϑ , and the righthand side gives a multiplicative decomposition of that P -special semimartingale as


45

the product of a local martingale and a process of finite variation; see Théorème 6.17 in [13]. But now the uniqueness of the multiplicative decomposition and the fact that E(L) exp(B) is a P -supermartingale together imply that B = B(π) must be a 1,++ ). decreasing process, for every π (coming from a ϑ such that X 1,ϑ lies in Xnp By a standard variational argument, this is only possible if A = d M π , and because π np is in L2loc (M), we see that (SC) is satisfied with λ = π np . Putting everything together, we now obtain the main result of this section. Theorem 7 For an Rd -valued continuous semimartingale S, the following are equivalent: 1) 2) 3) 4) 5) 6) 7) 8) 9)

S satisfies NUPBR. The numeraire portfolio X np exists. The growth-optimal portfolio X go exists. There exists an equivalent supermartingale deflator for X 1,++ : Y = ∅. ++ There exists a strictly positive local P -martingale density for S: Dloc (S, P ) = ∅. S satisfies the structure condition (SC). S satisfies the weak structure condition (SC ) and λ ∈ L2loc (M). T < ∞ P -a.s. S satisfies the weak structure condition (SC ) and K S satisfies the weak structure condition (SC ) and the minimal martingale den exists in D++ (S, P ). sity Z loc

In each of these cases, we then have X np = X go = 1/Z. Proof The equivalence of 1)–4) is the statement of Theorem 3. The equivalence of 5)–9) comes from Proposition 4 and directly from the definitions. Lemma 5 shows that 6) implies 2), and Proposition 6 conversely shows that 2) implies 6). The final statement is due to Theorem 3 and Lemma 5. We emphasise once again that all the individual results in this section are known. However, we have not seen anywhere so far the full list of equivalences compiled in Theorem 7, and so we hope that the result may be viewed as useful. Remarks 1) Because our main interest here lies on the numeraire or growth-optimal portfolio, we have focussed exclusively on the (equivalent) condition NUPBR. There is in fact a whole zoo of absence-of-arbitrage conditions, and an extensive discussion and comparison of these in the framework of a continuous financial market can be found in Chap. 1 of [12]. That work also contains many more details as well as explicit examples and counterexamples. 2) We already know from Proposition 1 that there is a close connection between the log-utility-optimal portfolio and the numeraire portfolio. If S is continuous, this

46


maximises turns out to be rather transparent. Indeed, if S satisfies (SC), then 1/Z 1,ϑ 1,ϑ 1, ++ E[log XT ] over all X ∈ X , and the maximal expected utility is

T ) = 1 E K T ∈ [0, ∞]. E log(1/Z 2 So existence of the log-utility-optimal portfolio with finite maximal expected utility is equivalent to the structure condition (SC) plus the extra requirement T ] < ∞. For more details, we refer to part 1) of Theorem 3.5 in [1]. that E[K 3) We have already seen in Sect. 2 that the condition NFLVR is equivalent to the combination of the conditions NUPBR and NA. The latter can be formulated as saying that whenever ϑ is admissible, i.e. a-admissible for some a ≥ 0, XT0,ϑ ≥ 0 P -a.s. implies that XT0,ϑ = 0 P -a.s. A slightly different condition is (NA+ ) which stipulates that whenever ϑ is 0-admissible, XT0,ϑ ≥ 0 P -a.s. implies that X 0,ϑ ≡ 0 P -a.s. We mention this condition because it is just a little weaker than NUPBR. In fact, if S is continuous, Theorem 3.5 of [27] shows that S satisfies (NA+ ) if and only if S satisfies the weak structure condition (SC ) and the mean-variance does not jump to +∞, i.e. tradeoff process K t+δ λtru d M u λu = +∞ for all δ ∈ (0, T − t] = ∞. inf t > 0 t

T < ∞ P -a.s., so that The second condition follows from, but does not imply, K (NA+ ) is a little weaker than (SC), or equivalently NUPBR.

4 Minimal Market Models The notion of a minimal market model is due to E. Platen and has been introduced in a series of papers with various co-authors; see Chap. 13 of [24] for a recent textbook account. Our goal in this section is to link that concept to the notions introduced in Sects. 2 and 3 and to exhibit a fundamental probabilistic structure result for such models. The presentation here is strongly inspired by Chap. 5 of [12], but extends and simplifies the analysis and results given there. The latter Chap. 5 is in turn based on Chaps. 10 and 13 from [24], although the presentation is a bit different. The key idea behind the formulation of a minimal market model is an asymptotic diversification result due to E. Platen. Theorem 3.6 of [23] states that under fairly weak assumptions, a sequence of well-diversified portfolios converges in a suitable sense to the growth-optimal portfolio. It is therefore natural to model a broadly based (hence diversified) index by the same structure as the growth-optimal portfolio, and to call such a model for an index a minimal market model. To study this, we therefore have to take a closer look at the probabilistic behaviour of the growth-optimal portfolio. We begin by considering a continuous financial market model almost as in Sect. 3. More precisely, let S = (St )t≥0 be a continuous Rd -valued semimartingale on (Ω, F , F, P ) with F = (Ft )t≥0 . We assume that S satisfies NUPBR on [0, T ] for every T ∈ (0, ∞) so that we can use Theorem 7 for every fixed finite T . We thus


47

obtain S = S0 + M + d M λ with λ ∈ L2loc (M), the minimal martingale density = E(− Z λ . M) exists, and so does the growth-optimal portfolio X go , which coin All this is true on [0, ∞) since it holds on every interval [0, T ] and cides with 1/Z. we can simply paste things together. The minimal market model for the index I = (It )t≥0 is now defined by = 1/E(− λ . M). I := X go = 1/Z

(2)

In view of the remark after Proposition 4, this shows that the minimal market model (MMM) is directly connected to the minimal martingale measure (MMM), or more It also explains why we have delibprecisely to the minimal martingale density Z. erately avoided the use of the abbreviation MMM and gives a clear hint where the title of this paper comes from. The next result is the key for understanding the probabilistic structure of the process I in (2). Recall the notation . for stochastic integrals. Proposition 8 Suppose N = (Nt )t≥0 is a real-valued continuous local martingale null at 0, and V = (Vt )t≥0 is defined by V := 1/E(−N ) = E(N + N ). Then: 1) {V . N ∞ = +∞} = { N ∞ = +∞} 2) If N ∞ = +∞ P -a.s., then

P -a.s.

Vt = C t ,

t ≥ 0,

where C = (Ct )t≥0 is a squared Bessel process of dimension 4 (a BESQ4 , for short) and the time change t → t is explicitly given by the increasing process 1 1 t 1 t t = d N s = Vs d N s , t ≥ 0. 4 0 E(−N )s 4 0 3) The result in 2) is also valid without the assumption that N ∞ = +∞ P -a.s. if we are allowed to enlarge the underlying probability space in a suitable way. Proof The second expression for V follows directly from the explicit formula for the stochastic exponential E(−N ). 1) This is fairly easy, but for completeness we give details. By Proposition V.1.8 of [25], the sets {N∞ := limt→∞ Nt exists in R} and { N ∞ < ∞} are equal with probability 1. So on { N ∞ < ∞}, the process E(−N )s = exp(−Ns − 12 N s ) converges to exp(−N∞ − 12 N ∞ ) > 0 P -a.s. which implies that s → Vs = 1/E(−N )s remains bounded P -a.s. as s → ∞. Hence V . N ∞ (ω) ≤ const. (ω) N ∞ (ω) < ∞ P -a.s. on N ∞ < ∞ . On the other hand, N ∈ Mc0,loc implies by Fatou’s lemma that s → E(−N )s is a nonnegative supermartingale and therefore converges P -a.s. to a finite limit (which might be 0) as s → ∞. So s → 1/Vs = E(−N )s is bounded P -a.s. and thus 1 N ∞ (ω) = +∞ P -a.s. on N ∞ = +∞ . V . N ∞ (ω) ≥ const. (ω) This proves the assertion.

48


2) Because V = E(N + N ) satisfies dV = V dN +V d N , defining L ∈ Mc0,loc √ by dL = 12 V dN yields d L = 14 V d N and √ dV = 2 V dL + 4 d L . By 1), N ∞ = +∞ P -a.s. implies that L ∞ = 14 V . N ∞ = +∞ P -a.s., and so the Dambis–Dubins–Schwarz theorem (see Theorem V.1.6 in [25]) yields the existence of some Brownian motion B = (Bt )t≥0 such that Lt = B L t for t ≥ 0. Hence dVt = 2 Vt dB L t + 4 d L t , and if t → τt denotes the inverse of t → L t , we see that Ct := Vτt , t ≥ 0, satisfies dCt = 2 Ct dBt + 4 dt, so that C is a BESQ4 process; see Chap. XI of [25]. Finally, since τ and L are inverse to each other, Vt = C L t and as claimed, the time change t → t is given by 1 t = L t = V . N t , t ≥ 0. 4 3) If we may enlarge the probability space to guarantee the existence of an independent Brownian motion, we can still use the Dambis–Dubins–Schwarz theorem; see Theorem V.1.7 in [25]. Thus the same argument as for 2) still works. In view of Theorem 7, applying Proposition 8 with N = λ . M and noting that N = K now immediately gives the main result of this section. Theorem 9 Let S = (St )t≥0 be an Rd -valued continuous semimartingale and suppose that S satisfies NUPBR on [0, T ] for every T ∈ (0, ∞) (or equivalently that the growth-optimal portfolio X go exists for every finite time horizon T ). Denote = E(− by Z λ . M) the minimal martingale density for S and model the index Then It = C t , t ≥ 0, is a time change of a squared I = (It )t≥0 by I := X go = 1/Z. Bessel process C of dimension 4, with the time change given by 1 t 1 d Ks , t ≥ 0. (3) t = s 4 0 Z Theorem 9 is a generalisation of Proposition 5.8 in [12], where the same conclusion is obtained under the more restrictive assumption that S is given by a multidimensional Itô process model which is complete. But most of the key ideas for the above proof can already be seen in that result of [12]. Even considerably earlier, the same result as in [12] can be found in Sect. 3.1 of [22], although it is not stated as a theorem. The main contribution of Theorem 9 is to show that neither completeness nor the Itô process structure are needed. Example 10 To illustrate the theory developed so far, we briefly consider the standard, but incomplete multidimensional Itô process model for S. Suppose discounted asset prices are given by the stochastic differential equations

On Minimal Market Models and Minimal Martingale Measures m dSti i = (μ − r ) dt + σtik dWtk t t Sti k=1

49

for i = 1, . . . , d and 0 ≤ t ≤ T .

Here W = (W 1 , . . . , W m )tr is an Rm -valued standard Brownian motion on (Ω, F , P ) with respect to F; there is no assumption that F is generated by W , and we only suppose that m ≥ d so that we have at least as many sources of uncertainty as risky assets available for trade. The processes r = (rt )t≥0 (the instantaneous short rate), μi = (μit )t≥0 (the instantaneous drift rate of asset i) for i = 1, . . . , d and σ ik = (σtik )t≥0 for i = 1, . . . , d and k = 1, . . . , m (the instantaneous volatilities) are predictable (or even progressively measurable) and satisfy T d T d m T |ru | du + |μiu | du + (σuik )2 du < ∞ 0

i=1 0

i=1 k=1 0

P -a.s. for each T ∈ (0, ∞). Moreover, to avoid redundant assets (locally in time), we assume that for each t ≥ 0, the d × m-matrix σt has P -a.s. full rank d. σt σttr

is P -a.s. invertible and we can define the predictable (or progressively Then measurable) Rm -valued process λ = (λt )t≥0 by λt := σttr (σt σttr )−1 (μt − rt 1), with that

1 = (1, . . . , 1)tr

∈ Rd . Our final assumption is

T

|λu |2 du < ∞

t ≥0

that λ ∈ L2loc (W ) or equivalently

P -a.s. for each T ∈ (0, ∞).

(4)

0

Sometimes λ (instead of λ below) is called the (instantaneous) market price of risk for S. It is straightforward to verify that the canonical decomposition of the continuous semimartingale S i is given by = Sti

dMti

m

σtik dWtk

and dAit = Sti (μit − rt ) dt,

k=1

so that i

d M , M

j

j

t = Sti St

m

jk

j

σtik σt dt = Sti St (σt σttr )ij dt.

k=1

The weak structure condition (SC ) is therefore satisfied with the Rd -valued process λ = ( λt )t≥0 given by i 1 λit = i (σt σttr )−1 (μt − rt 1) for i = 1, . . . , d and t ≥ 0. St This gives λ dM = λ dW and therefore the mean-variance tradeoff process as t t = λ . M t = λ . W t = |λu |2 du for t ≥ 0, K 0

50


and so (4) immediately implies that S satisfies (SC) on [0, T ] for each T ∈ (0, ∞). Therefore this model directly falls into the scope of Theorem 7 (for each fixed T ) and of Theorem 9. In particular, we of course recover Proposition 5.8 of [12] or the result from Sect. 13.1 of [24] as a special case (for m = d, even without the stronger assumptions imposed there). Remark To obtain a more concrete model just for the index I , Theorem 9 makes it very tempting to start with a BESQ4 process C and choose some time change t → t to then define the index by It := C t ,

t ≥ 0.

(5)

Depending on the choice of , this may provide a good fit to observed data and hence yield a plausible and useful model; see Sect. 13.2 of [24] on the stylised minimal market model. However, a word of caution seems indicated here. In fact, if we accept (as in this section) the basic modelling of the index I by the growthoptimal portfolio X go , then the approach (5) raises the following inverse problem: Given a time change t → t , when does there exist an Rd -valued continuous semimartingale S = (St )t≥0 which satisfies the structure condition (SC) and whose growth-optimal portfolio is given by the process I defined by (5)? We do not have an answer to this question, but we suspect that the problem is nontrivial. One first indication for this is the observation that the explicit form (3) of the time change in Theorem 9 implies that t dK t , = 4Z d t

t ≥ 0.

(6)

and cannot Since the right-hand side of (6) is a local martingale, the processes K be chosen with an arbitrarily simple structure — for example they cannot both be deterministic. Acknowledgements MS gratefully acknowledges financial support by the National Centre of Competence in Research “Financial Valuation and Risk Management” (NCCR FINRISK), Project D1 (Mathematical Methods in Financial Risk Management). The NCCR FINRISK is a research instrument of the Swiss National Science Foundation. We also thank an anonymous referee for helpful suggestions and useful comments.

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The Economic Plausibility of Strict Local Martingales in Financial Modelling Hardy Hulley

Abstract The context for this article is a continuous financial market consisting of a risk-free savings account and a single non-dividend-paying risky security. We present two concrete models for this market, in which strict local martingales play decisive roles. The first admits an equivalent risk-neutral probability measure under which the discounted price of the risky security is a strict local martingale, while the second model does not even admit an equivalent risk-neutral probability measure, since the putative density process for such a measure is itself a strict local martingale. We highlight a number of apparent anomalies associated with both models that may offend the sensibilities of the classically-educated reader. However, we also demonstrate that these issues are easily resolved if one thinks economically about the models in the right way. In particular, we argue that there is nothing inherently objectionable about either model.

1 Introduction The setting for this article is a continuous financial market consisting of a single non-dividend-paying risky security and a risk-free money-market account. We consider two models for the price of the risky security, both of which are affected by the presence of strict local martingales. The first model admits an equivalent riskneutral probability measure under which the discounted price of the risky security is a strict local martingale. In particular, this model satisfies the strong no-arbitrage requirement of “no free lunch with vanishing risk” (NFLVR) (see [5]). The second model, on the other hand, does not even admit an equivalent risk-neutral probability measure, since the density process associated with the putative equivalent riskneutral probability measure is a strict local martingale. Nevertheless, we shall see For Eckhard Platen on the occasion of his 60th birthday, with gratitude. H. Hulley () School of Finance and Economics, University of Technology, Sydney, P.O. Box 123, Broadway, NSW 2007, Australia e-mail: [email protected] C. Chiarella, A. Novikov (eds.), Contemporary Quantitative Finance, DOI 10.1007/978-3-642-03479-4_4, © Springer-Verlag Berlin Heidelberg 2010

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H. Hulley

that this model does possess a numéraire portfolio, which ensures that it satisfies the weaker no-arbitrage requirement of “no unbounded profit with bounded risk” (NUPBR) (see [15]). Following the terminology introduced by [9], we shall say that the first model is an example of a “stock price bubble,” while the second model is an example of a “bond price bubble.” Stock price bubbles have recently become a popular topic in the literature (see e.g. [3, 7, 9, 11, 12]). Although such models remain firmly within the ambit of the risk-neutral approach to contingent claim pricing, they nevertheless exhibit a number of anomalies that have occupied the research articles cited above. For example, the risk-neutral forward price of the risky security is strictly less than its spot price grossed-up at the risk-free interest rate. Furthermore, the risk-neutral prices of European puts and calls on the risky security no longer obey the put-call parity relationship. By contrast, bond price bubbles have received comparatively little attention in the literature—possibly due to a misguided concern about their arbitrage properties. The only obvious exception is the so-called “benchmark approach” of [17], which develops a systematic approach to the pricing and hedging of contingent claims in financial markets that possess a numéraire portfolio, without necessarily admitting an equivalent risk-neutral probability measure. The resulting pricing methodology is referred to as “real-world pricing,” since it does not rely on any equivalent change of probability measure. At first blush, the real-world prices of contingent claims for the bond price bubble also appear to exhibit a number of anomalies. For example, the real-world price of a zero-coupon bond turns out to be strictly less than the discounted value of its principal. It is also possible to generate a risk-free profit from no initial investment, by constructing a portfolio whose value is bounded from below. In this article we analyze the pricing and hedging of contingent claims written on the risky security, for both the stock price bubble and the bond price bubble. Our main objective is to demonstrate that the anomalies associated with strict local martingales are actually not so strange after all. In particular, if one thinks economically about the strict local martingales in our two models, then the apparently strange behaviour of contingent claim prices begins to seem quite natural. The remainder of the paper is structured as follows: Sect. 2 introduces the two models, both of which are based on a Bessel process of dimension three. Section 3 then derives pricing formulae and hedge ratios for a number of European contingent claims written on the risky security, for the case of the stock price bubble. By analyzing the behaviour of these pricing formulae and hedge ratios, we argue that the anomalies associated with the claim prices for the stock price bubble are easily resolved. Section 4 then performs a similar analysis, for the case of the bond price bubble.

2 An Overview of the Two Models As stated in the introduction, the subject of this article is a financial market consisting of a single non-dividend-paying risky security and a risk-free money-market account. We are concerned with the following two models for the price S of the risky security:

The Economic Plausibility of Strict Local Martingales in Financial Modelling

dSt = −St2 dβt

55

(1a)

and dSt =

1 dt + dβt , St

(1b)

for all t ∈ R+ . Here β is a standard Brownian motion residing on a filtered probability space (Ω, F , F, P), whose filtration F = (Ft )t∈R+ satisfies the usual conditions. We also adopt the standard convention of assuming that the risk-free interest rate is zero, so that the value of the money-market account is given by B = 1. Observe that the process specified by (1a) is by inspection a local martingale. The first of the two models presented above thus clearly satisfies the NFLVR condition, since P is itself the (unique) equivalent risk-neutral probability measure. In particular, the density process for the equivalent risk-neutral probability measure for that model is given by Z = 1. However, there is more to it than that, since the process described by (1a) is in fact the inverse of a Bessel process of dimension three, and is therefore a well-known example of a strict local martingale (see e.g. [18, Ex. V.2.13, p. 194]). This establishes the first model as an example of a stock price bubble. In the case of the second model, (1b) expresses the price of the risky security as a Bessel process of dimension three. It then follows that S is the numéraire portfolio for that model (in the sense of [2, Definition 4.1]), since B/S = 1/S and S/S = 1 are both non-negative local martingales, and consequently also supermartingales, by Fatou’s lemma. The model therefore satisfies the NUPBR condition, by virtue of [15, Theorem 4.12].1 However, it does not satisfy the NFLVR condition, since the density process for the putative equivalent risk-neutral probability measure may be expressed in terms of the numéraire portfolio as follows: Z = (S0 /B0 )(B/S) = S0 /S, which is a strict local martingale.2 This establishes the second model as an example of a bond price bubble. We acknowledge that the models presented by (1a) and (1b) have already been studied in detail by [4] and [6], respectively. However, whereas the above-mentioned articles focus on questions of arbitrage, we wish to address the pricing and hedging of contingent claims. Our paper may therefore be regarded as a companion for those articles. We begin our discussion of contingent claim pricing by introducing a finite maturity date T > 0 and a payoff function h : (0, ∞) → R+ , which satisfy the following three conditions: 1 Actually, this is not completely true, since Theorem 4.12 of [15] requires the value of the numéraire portfolio to be a “semimartingale up to infinity.” The Bessel process of dimension three does not meet this requirement, since its sample paths diverge in the limit as time goes to infinity. Nevertheless, this provides no practical obstacle, since our applications only involve a finite time-horizon. 2 Strictly speaking, we are abusing terminology by calling Z a density process in this instance, since most of the literature adopts the convention that density processes are positive martingales. In the case of the second model, it may therefore be more appropriate to describe Z as a “predensity process” or a “candidate density process.” However, in the interest of maintaining a uniform terminology for discussing both models, we shall continue to refer to Z simply as a density process, with the understanding that the reader is sufficiently flexible on this point.

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(i) h is continuous and of polynomial growth; (ii) EZT h(ST ) < ∞; and (iii) P h(ST ) > 0 > 0. We now consider a European contingent claim on the risky security, with maturity T and payoff h(ST ). We denote the value of this claim by the process V h = (Vth )t∈[0,T ] , which is determined as follows: Vth :=

1 E ZT h(ST ) Ft , Zt

(2)

for all t ∈ [0, T ]. Observe that Vth < ∞, for all t ∈ [0, T ], by virtue of condition (ii) above, while condition (iii) ensures that Vth > 0, for all t ∈ [0, T ). Also, note that since VTh = h(ST ), it easily follows that the process (Zt Vth )t∈[0,T ] is a martingale. We shall refer to (2) as the “real-world” price of the claim, since it does not require any transformation of probability measure.3 For the first model it is easily seen that (2) agrees with the risk-neutral price of the claim, since Z is a martingale. However, it is also clear that (2) remains well-defined for the second model. In that case there is no equivalent risk-neutral probability measure, since Z is a strict local martingale, and hence risk-neutral pricing is infeasible. In other words, real-world pricing offers a proper extension of the risk-neutral pricing concept. An important observation for the two models under consideration is that 1 if the risky security price satisfies (1a), ZT = St Zt if the risky security price satisfies (1b), ST for all t ∈ [0, T ]. We may therefore exploit the Markov property of the price of the risky security, for both models, by writing Vth = V h (t, St ), for all t ∈ [0, T ], where the “pricing function” V h : [0, T ] × (0, ∞) → R+ that appears in this expression may be computed as follows: Et,S h(ST ) h if the risky security price satisfies (1a), V (t, S) := (3) h(ST ) if the risky security price satisfies (1b), S Et,S ST for all (t, S) ∈ [0, T ] × (0, ∞).4 The following proposition will allow us to obtain convenient expressions for the pricing functions of a number of standard European contingent claims in Sects. 3 and 4: 3 The reader is directed to Sect. 9.1 of [17] for a more detailed account of the real-world approach to contingent claim pricing. Note that real-world prices are expressed there in terms of the numéraire portfolio, whereas (2) expresses them in terms of the density process. These two formulations are equivalent, by dint of the fact that the density process is proportional to the numéraire-denominated money-market account. 4 As

usual, Et,S denotes the expected value operator with respect to the probability measure Pt,S , under which the price of the risky security at time t ∈ R+ is S ∈ (0, ∞). Of course, we are abusing notation slightly by using S to denote a particular value for the price of the risky security, as well the price process for this asset.


57

Proposition 1 A Bessel process of dimension three has the following (truncated) moments: x+z x 1 x 1 x −z Ex 1{t ≤z} −Φ √ + Φ √ − Φ −√ , (4) = Φ − √ t x t t t t x 1 1 x , (5) = Φ √ − Φ −√ Ex t x t t x+z 1 x−z 1 Ex 1{t >z} −Φ − √ , (6) = Φ √ t x t t √ x+z x −z x −z x +z t Px (t ≤ z) = Φ √ −Φ √ + −ϕ √ , (7) ϕ √ x t t t t and

√ x −z x−z x +z t x +z +Φ √ − −ϕ √ , (8) ϕ √ x t t t t

Px (t > z) = Φ − √

for all t > 0, x, y ∈ (0, ∞) and z > 0.5 In these expressions Φ denotes the cumulative distribution function of a standard normal random variable, while ϕ is the associated density function.6 Proof To begin with, [18, Proposition VI.3.1, p. 251] provides the following expression for the transition density of : 3 2 xy x + y2 ∂ x y 2 exp − , q(t, x, y) := Px (t ≤ y) = I1 2 ∂y t x t 2t

5 In this case E x

should be understood as the expected value operator with respect to the probability measure Px , under which 0 = x, for all x ∈ (0, ∞).

6 In

other words,

Φ(z) :=

z −∞

1 2 √ e−ζ /2 dζ, 2π ϕ(ζ )

for all z ∈ R. Also, recall that the mapping R ζ →

1 ζ −μ ϕ σ σ

is the probability density function of a normal random variable with mean μ ∈ R and standard deviation σ > 0.

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H. Hulley

for all t > 0 and x, y ∈ (0, ∞). The function I1/2 that appears above is the modified Bessel function of the first kind with index one half (see e.g. [1, Chap. 9]). It satisfies the following identity: 1 2 I 1 (z) = sinh z = √ (ez − e−z ), 2 πz 2πz for all z ∈ R, according to [16, Eq. 5.8.5, p. 112]. By combining these two expressions, we obtain 1 y 1 y −x y+x −√ ϕ √ , q(t, x, y) = √ ϕ √ x t t t t for all t > 0 and x, y ∈ (0, ∞). Now, fix t > 0, x ∈ (0, ∞) and z > 0, and observe that z 1 1 = q(t, x, y) dy Ex 1{t ≤z} t 0 y z

z 1 1 1 y −x y +x dy − dy . = √ ϕ √ √ ϕ √ x 0 t t t t 0 Since the final expression above involves the difference between the truncated zeroth moments of two normal random variables, we obtain (4) from [13, Table 1], for example. We may then derive (5) from (4), by an application of the monotone convergence theorem, while (6) follows directly from (4) and (5). Next, we see that z

z

z y y 1 y−x y +x dy − dy . Px (t ≤ z) = q(t, x, y) dy = √ ϕ √ √ ϕ √ x 0 t t t t 0 0 In this case we recognize that the final expression above involves the difference between the truncated first moments of two normal random variables. Once again, we may look these up in [13, Table 1], to get (7). Finally, (8) is obtained directly from (7). We turn our attention now to the question of how to hedge the contingent claim introduced above, for the two models under consideration. To begin with, throughout this article the phrase “viable portfolio” should be understood to mean a selffinancing portfolio consisting of holdings in the risky security and the money-market account, whose value is strictly positive over [0, T ) and non-negative at time T .7 Such a portfolio may be presented by a “trading strategy” π = (πt )t∈[0,T ) , which specifies the fraction of its wealth invested in the risky security. Given an initial endowment x > 0 and a trading strategy π = (πt )t∈[0,T ) for a viable portfolio, the 7 Strictly speaking, the last requirement is redundant, since all self-financing portfolios in the financial market introduced above have continuous sample paths.


59

associated “wealth process” W x,π = (Wtx,π )t∈[0,T ] is easily seen to satisfy one of the following two stochastic differential equations: dWtx,π = −πt St Wtx,π dβt

(9a)

or dWtx,π =

πt x,π πt Wt dt + Wtx,π dβt , 2 St St

(9b)

for all t ∈ [0, T ), depending on whether the price of the risky security is modelled by (1a) or by (1b).8 As an aside, observe that (9) suggests the following stochastic exponential representation for the wealth of a viable portfolio with initial endowment x > 0 and trading strategy π = (πt )t∈[0,T ) : · x,π Wt = xE πs dXs , 0

t

for all t ∈ [0, T ]. The process X in the expression above is given by dXt = −St dβt

(10a)

or dXt =

1 1 dt + dβt , St St2

(10b)

for all t ∈ R+ , depending on whether the price of the risky security is determined by (1a) or by (1b). The requirement that the portfolio wealth is strictly positive over [0, T ) then translates into the following concrete condition:

t πs2 d X s < ∞, 0

for all t ∈ [0, T ). Moreover, we obtain the following correspondence between events: T x,π 2 πs d X s = ∞ , WT = 0 = 0

by an application of the law of large numbers for local martingales (see e.g. [18, Ex. V.1.16, pp. 186–187]). It will be useful for us to identify two notions of hedging, for the contingent claim introduced earlier. The first of these corresponds to the situation when the value of a viable portfolio precisely matches the payoff of the claim at its maturity, while the second describes the situation when the value of a viable portfolio precisely matches the real-world price of the claim at all times up to its maturity: 8 Of course, π

should belong to an appropriate class of processes in order for the stochastic integrals in (9) to be well-defined. For example, we could stipulate that all trading strategies should be progressively measurable.

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Definition 2 Consider a viable portfolio, which is determined by an initial endowment x > 0 and a trading strategy π = (πt )t∈[0,T ) . (i) The portfolio is said to “hedge the claim” if and only if WTx,π = h(ST ). (ii) The portfolio is said to “replicate the claim” if and only if Wtx,π = Vth , for all t ∈ [0, T ]. It is immediately evident from the definition above that any viable portfolio that replicates the claim must also hedge it. To make the relationship between hedging and replication more explicit, suppose that the initial endowment x hed > 0 and trading strategy π hed = (πthed )t∈[0,T ) specify a viable portfolio that hedges the claim. Similarly, let the initial endowment x rep > 0 and trading strategy π rep = (πtrep )t∈[0,T ) specify a viable portfolio that replicates the claim. We begin by observing that the rep rep process Zt Wtx ,π t∈[0,T ] is a martingale, since Zt Wtx

rep

,π rep

rep rep = Zt Vth = E ZT VTh Ft = E ZT WTx ,π Ft ,

for all t ∈ [0, T ], by virtue of the already established fact that (Zt Vth )t∈[0,T ] is a hed hed martingale. Next, we note that the process Zt Wtx ,π t∈[0,T ] is a local martingale. In the case of the stock price bubble, this is an easy consequence of (9a) and the fact that Z = 1. In the case of the bond price bubble, the stochastic integration by parts formula yields 1 hed hed hed hed ZW x ,π = − 1 − πthed dβt , d ZW x ,π t t St for all t ∈ [0, T ), with the help (9b) and the fact that Z = S0 /S. We may therefore hed hed deduce that Zt Wtx ,π t∈[0,T ] is in fact a supermartingale, for both models, by an application of Fatou’s lemma. Finally, putting all of the above together, we obtain rep rep rep rep hed hed hed hed Zt Wtx ,π = E ZT WTx ,π Ft = E ZT WTx ,π Ft ≤ Zt Wtx ,π , for all t ∈ [0, T ]. In particular, since Z > 0 for both the stock price bubble and the bond price bubble, we must have Wtx

rep

,π rep

≤ Wtx

hed

,π hed

,

(11)

for all t ∈ [0, T ], irrespective of which model is chosen. The importance of (11) lies in the justification it provides for the real-world pricing formula (2). In particular, since the value of the replicating portfolio—if it exists—corresponds with the real-world price of the claim, we see that the realworld price represents the value of the cheapest possible hedging portfolio. This raises the following two important questions: Does the replicating portfolio necessarily exist, and can we characterize it? These questions are addressed by the next proposition, for which the crucial ingredient is a converse for the Feynman-Kac Theorem, due to [10]:


61

Proposition 3 Let x rep : (0, ∞) → (0, ∞) and π rep : [0, T ) × (0, ∞) → R+ be defined as follows: E0,S h(ST ) if the risky security price satisfies (1a), rep h(ST ) x (S) := (12) if the risky security price satisfies (1b), S E0,S ST for all S ∈ (0, ∞), and π rep (t, S) :=

∂V h S (t, S), V h (t, S) ∂S

(13)

for all (t, S) ∈ [0, T ) × (0, ∞), respectively. In particular, (13) is well-defined, since the pricing function (3) is both strictly positive and differentiable. The replicating portfolio for the contingent claim under consideration is then determined by the initial endowment x rep = x rep (S0 ) and the trading strategy π rep = (πtrep )t∈[0,T ) , with πtrep = π rep (t, St ), for all t ∈ [0, T ). Proof We have already observed that by imposing condition (iii) on the payoff function, we guarantee that the pricing function is strictly positive, for both the stock price bubble and the bond price bubble. So to establish that the expression in (13) is well-defined, we need only demonstrate that the pricing function of the claim is differentiable. We shall now analyze the stock price bubble and the bond price bubble separately: (i) Suppose the price of the risky security is modelled by (1a). It then follows from [10, Theorem 6.1] that the pricing function (3) is continuously differentiable with respect to the temporal variable and twice continuously differentiable with respect to the spatial variable, and that it satisfies the following partial differential equation: ∂V h 1 ∂ 2V h (t, S) + S 4 (t, S) = 0, ∂t 2 ∂S 2

(14)

for all (t, S) ∈ [0, T ) × (0, ∞).9 The differentiability of the pricing function ensures that the trading strategy (13) is well-defined, while Itô’s formula combined with (14) yields dV (t, St ) = h

h ∂V h 1 4 ∂ 2V h 2 ∂V (t, St ) + St (t, St ) dβt (t, S ) dt − S t t ∂t 2 ∂S ∂S 2

= −St2

∂V h (t, St ) dβt ∂S

= −π rep (t, St )St V h (t, St ) dβt ,

(15)

9 Note that Theorem 6.1 of [10] requires a continuous payoff function of polynomial growth. This explains why we imposed condition (i) when we introduced the payoff function for the claim.

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H. Hulley

for all t ∈ [0, T ). Finally, since x rep (S0 )=V h (0, S0 ), we see that Wtx for all t ∈ [0, T ], by comparing (15) with (9a).

rep

,π rep

=V h (t, St ),

(ii) Suppose the price of the risky security is modelled by (1b), and consider the h : [0, T ] × (0, ∞) → R+ , given by function V h h (t, S) := V (t, S) , V S

(16)

for all (t, S) ∈ [0, T ] × (0, ∞). It then follows from [10, Theorem 6.1] and (3) that the function defined by (16) is continuously differentiable with respect to the temporal variable and twice continuously differentiable with respect to the spatial variable, and that it satisfies the following partial differential equation: h h h ∂V 1 ∂V 1 ∂ 2V (t, S) + (t, S) + (t, S) = 0, ∂t S ∂S 2 ∂S 2

(17)

for all (t, S) ∈ [0, T ) × (0, ∞). In particular, the differentiability of this function implies that the pricing function is differentiable, from which it follows that the trading strategy (13) is well-defined. Next, by combing (17) with (16), we obtain the following partial differential equation for the pricing function itself: ∂V h 1 ∂V h 1 ∂ 2V h 1 ∂V h (t, S) + (t, S) + (t, S) = 0, (t, S) − ∂t S ∂S 2 ∂S 2 S ∂S

(18)

for all (t, S) ∈ [0, T ) × (0, ∞). By combining Itô’s formula with (18), we then get dV h (t, St ) =

∂V h 1 ∂V h 1 ∂ 2V h (t, St ) + (t, St ) + (t, S ) dt t ∂t St ∂S 2 ∂S 2

+

∂V h (t, S) dβt ∂S

=

1 ∂V h ∂V h (t, St ) dt + (t, S) dβt St ∂S ∂S

=

π rep (t, St ) h π rep (t, St ) h V (t, St ) dt + V (t, St ) dβt , 2 St St

for all t ∈ [0, T ). Finally, since x rep (S0 )=V h (0, S0 ), we see that Wtx for all t ∈ [0, T ], by comparing (19) with (9b).

rep

,π rep

(19) =V h (t, St ),

Together, (11) and Proposition 3 establish the canonical nature of the real-world pricing formula: Given any payoff function satisfying conditions (i)–(iii) above, the real-world price of the corresponding claim provides the minimal cost of hedging it. Moreover, we see that the trading strategy (13) for the replicating portfolio may be expressed in terms of the “delta” of the claim. The latter is in turn completely


63

determined by a function Δh : [0, T ) × (0, ∞) → R, which is defined by Δh (t, S) :=

∂V h (t, S), ∂S

for all (t, S) ∈ [0, T ) × (0, ∞).

3 The Stock Price Bubble In this section we focus on the situation when the price of the risky security is modelled by (1a). Since its price is then an inverted Bessel process of dimension three, we may use Proposition 1 to derive the pricing functions and deltas for a number of standard European claims on the risky security, all of which share a common maturity date T > 0 and strike K > 0 (when appropriate). We begin by considering a zero-coupon bond with a face-value of one dollar.10 As one would expect, this instrument is trivial in the case of the stock price bubble. In particular, its delta is uniformly zero, so that its replicating portfolio consists simply of an initial endowment—equal to (the discounted value of) its principal— invested in the money-market account: Example 4 The pricing function Z : [0, T ) × (0, ∞) → (0, ∞) for a zero-coupon bond is given by Z(t, S) := Et,S (1) = 1,

(20)

for all (t, S) ∈ [0, T ) × (0, ∞). The associated replicating portfolio is determined by the delta ΔZ : [0, T ) × (0, ∞) → R of the contract, which is given by ΔZ (t, S) := for all (t, S) ∈ [0, T ) × (0, ∞).

∂Z (t, S) = 0, ∂S

(21)

Next, we examine a prepaid forward contract on the risky security.11 Its pricing function and delta are presented below, and are plotted in Fig. 1. Example 5 The pricing function F : [0, T ) × (0, ∞) → (0, ∞) for a prepaid forward on the risky security is given by 1/S , (22) F(t, S) := Et,S (ST ) = S 1 − 2Φ − √ T −t 10 Here a “dollar” should be interpreted as a generic unit of currency—we assume that the values of all instruments are denominated in “dollars.” 11 The principal difference between prepaid forwards and conventional forward contracts is that the latter are settled at maturity, while the purchaser of a prepaid forward pays an up-front premium for subsequent delivery of the underlying asset when the contract matures. In other words, a prepaid forward is simply a European call with a strike price of zero.

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H. Hulley

Fig. 1 The pricing function and the delta of a prepaid forward on the risky security (T = 1)

for all (t, S) ∈ [0, T ) × (0, ∞), by an application of (5). The associated replicating portfolio is determined by the delta ΔF : [0, T ) × (0, ∞) → R of the contract, which is given by 1/S 1/S ∂F 2 F (t, S) = 1 − 2Φ − √ ϕ √ , (23) − √ Δ (t, S) := ∂S T −t T −t S T −t for all (t, S) ∈ [0, T ) × (0, ∞).

We immediately notice from Fig. 1 that the value of the prepaid forward contract is strictly less than the price of the risky security itself, at all times prior to maturity. In particular, we have 1/S > 0, (24) S − F (t, S) = 2SΦ − √ T −t γ (t,S)

for all (t, S) ∈ [0, T ) × (0, ∞). The process (γ (t, St ))t∈R+ introduced above corresponds with what [8] refer to as the “default” of a strict local martingale (in this case the price of the risky security). Another interesting observation is that the price of the prepaid forward is bounded from above at any fixed time t ∈ [0, T ), since (22) yields 2 . lim F(t, S) = √ 2π(T − t)

S↑∞

(25)

This explains why one cannot hope to exploit any arbitrage opportunity by simultaneously purchasing the prepaid forward and short-selling the underlying risky security—the value of the resulting portfolio is not bounded from below. It also explains why, for large values of the risky security price, the portfolio that replicates the prepaid forward is almost completely invested in the money-market account, as


65

evidenced by the surface plot of its delta in Fig. 1. In particular, (25) ensures that the delta of the prepaid forward is zero in the limit, as the price of the risky security increases to infinity. Let us now attempt to explain the intuition behind the fact that the prepaid forward is worth less than its underling risky security. To begin with, consider for a moment a model that does admit an equivalent risk-neutral probability measure, under which the (discounted) price of the risky security is in fact a martingale. In such a case the risk-neutral value of the prepaid forward would exactly match the market price of the risky security. This phenomenon is often interpreted to mean that risk-neutral valuation allows one to retrieve the price the risky security itself, by computing its discounted expected future value. By this line of reasoning the stock price bubble seems incoherent, since it appears that there are now two prices for the risky security: a market price and a model price. To resolve the conundrum above, we should first point out that the prices of the underlying primary securities (i.e. the risky security and the money-market account) are completely exogenous in the modelling framework considered here—they are what they are, and they are not subject to any valuation principle. The fact that the risk-neutral value of the prepaid forward agrees with the market price of the risky security, in the case when the (discounted) price of the risky security is a martingale under the equivalent risk-neutral probability measure, is simply a curiosity induced by the properties of martingales. In truth, the risky security and the prepaid forward contract written on it are fundamentally different instruments. To make this point clear, observe that the prepaid forward may also be regarded as a European call on the risky security with a strike price of zero. By the same token, the risky security may be regarded as an American call on itself, also with a strike price of zero. Seen in this light, it is not strange that the value of the prepaid forward should be less than the price of the risky security—the difference is simply an early exercise premium! Moreover, in the case of the stock price bubble—when the price of the risky security is expected to decrease over time—this early exercise premium becomes significant. In this way we would argue that the inequality (24) is in fact quite natural. The next instrument we consider is a European call on the risky security. Its pricing function and delta are presented below, and are plotted in Fig. 2. Example 6 The pricing function C : [0, T ) × (0, ∞) → (0, ∞) for a European call on the risky security is given by C(t, S) := Et,S (ST − K)+ = Et,S 1{ST >K} ST − K Pt,S (ST > K) 1/S − 1/K 1/S + 1/K = (S − K)Φ − √ + (S + K)Φ − √ T −t T −t 1/S − 2SΦ − √ T −t √ 1/S + 1/K 1/S − 1/K + KS T − t ϕ −ϕ , (26) √ √ T −t T −t

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Fig. 2 The pricing function and the delta of a call on the risky security (T = 1 and K = 1)

for all (t, S) ∈ [0, T ) × (0, ∞), by an application of (4) and (7). The associated replicating portfolio is determined by the delta ΔC : [0, T ) × (0, ∞) → R of the call, which is given by 1/S − 1/K 1/S + 1/K ∂C C (t, S) = Φ − √ Δ (t, S) := +Φ − √ ∂S T −t T −t S +K S −K 1/S − 1/K 1/S + 1/K + √ + √ ϕ ϕ √ √ S2 T − t T −t S2 T − t T −t 1/S 2 1/S − 2Φ − √ − √ ϕ √ T −t S T −t T −t 2 S − K − KS (T − t) 1/S − 1/K − ϕ √ √ S2 T − t T −t 1/S + 1/K S + K + KS 2 (T − t) ϕ , (27) − √ √ S2 T − t T −t for all (t, S) ∈ [0, T ) × (0, ∞).

It is evident from Fig. 2 that the call option exhibits similar anomalies to the prepaid forward contract. In particular, for the price of the call we obtain the following limit from (26): 1/K 2 lim C(t, S) = √ − K 2Φ √ −1 , (28) S↑∞ 2π(T − t) T −t for all t ∈ [0, T ). Once again, this implies that the call price is bounded from above at any fixed time prior to maturity. In addition, it establishes that the pricing function for the call does not preserve the convexity of its payoff function, with respect to the


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Fig. 3 The pricing function and the delta of a put on the risky security (T = 1 and K = 1)

price of the underlying risky security. This non-convexity is easily observed in the surface plot of the call delta in Fig. 2, where we see that the second derivative of the price of the call with respect to the price of the risky security is negative, for large enough prices of the risky security. Another easy consequence of (28) is that the slope of the call price with respect to the price of the risky security must tend to zero asymptotically, at any fixed time before maturity, for large values of the risky security price. In other words, the call delta should decrease to zero, when the price of the risky security becomes large, which implies that the replicating portfolio for the call should ultimately become fully invested in the money-market account. Once again, this phenomenon is illustrated by Fig. 2. The final claim considered in this section is a European put on the risky security. Expressions for its pricing function and delta are obtained below, and are plotted in Fig. 3. Example 7 The pricing function P : [0, T ) × (0, ∞) → (0, ∞) for a European put on the risky security is given by

P(t, S) := Et,S (K − ST )+ = K Pt,S (ST ≤ K) − Et,S 1{ST ≤K} ST

1/S + 1/K 1/S − 1/K = (S + K)Φ − √ − (S − K)Φ √ T −t T −t √ 1/S + 1/K 1/S − 1/K −ϕ + KS T − t ϕ , √ √ T −t T −t

(29)

for all (t, S) ∈ [0, T ) × (0, ∞), by an application of (4) and (7). The associated replicating portfolio is determined by the delta ΔP : [0, T ) × (0, ∞) → R of the

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put, which is given by ∂P 1/S − 1/K 1/S + 1/K Δ (t, S) := (t, S) = Φ − √ −Φ √ ∂S T −t T −t S−K 1/S + 1/K 1/S − 1/K S +K + √ ϕ ϕ + √ √ √ S2 T − t S2 T − t T −t T −t 2 1/S − 1/K S − K − KS (T − t) − ϕ √ √ 2 S T −t T −t 2 S + K + KS (T − t) 1/S + 1/K − , (30) ϕ √ √ S2 T − t T −t P

for all (t, S) ∈ [0, T ) × (0, ∞).

It is immediately evident from Fig. 3 that the behaviour of the put is much more conventional than that of the call. In particular, we see that the pricing function for the put preserves the convexity of its payoff function, with respect the price of the risky security, at all times prior to maturity. Furthermore, the delta of the put indicates that the replicating strategy for the claim converges to a short position in one share of the risky security, if the price of this security is very low, but has almost no exposure to the risky security, if its price is high. Once again, this corresponds with the “normal” behaviour of European puts under the assumptions of the BlackScholes model, for example. Finally, we turn our attention to the question of put-call parity. It is already wellknown that put-call parity fails for the stock price bubble, and we may confirm this explicitly, with the help of (26) and (29): 1/S C(t, S) − P(t, S) = S 2Φ √ − 1 − K < S − K, (31) T −t for all (t, S) ∈ [0, T ) × (0, ∞). There are two ways of interpreting the above inequality: Either the model is pathological, or else the put-call parity relationship is misspecified. We shall argue for the latter interpretation. To wit, note that putcall parity asserts an equivalence between a portfolio containing a long European call and a short European put, on the one hand, and a long position in the risky security combined with a short position in the money-market account, on the other hand. Since the latter portfolio offers investors the possibility of taking advantage of favourable interim movements in the price of the risky security, while the portfolio of European options does not, the inequality (31) simply expresses a type of early exercise premium associated with holding the underlying securities instead of the European options. In the case of the stock price bubble, where the price of the risky security is expected to decline over time, the flexibility associated with holding the underlying securities becomes valuable. A properly specified put-call relationship should only involve instruments that are European by nature, to avoid the type of phenomenon described above. We


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therefore propose the following as the correct formulation: C(t, S) − P(t, S) = F(t, S) − K Z(t, S),

(32)

for all (t, S) ∈ [0, T ) × (0, ∞). Note that this identity is easily verified for the stock price bubble, using the pricing functions presented in this section. Moreover, in Sect. 4 we shall see that (32) continues to hold for the case of the bond price bubble. It is therefore, in some sense, the fundamental statement of put-call parity.

4 The Bond Price Bubble This section examines the bond price bubble, when the price of the risky security is modelled by (1b). Since its price is a Bessel process of dimension three, in this case, we may once again apply Proposition 1 to derive the pricing functions and deltas for a number of European claims on the risky security, all of which share a common maturity date T > 0 and strike K > 0 (when appropriate). The first instrument we consider is a zero-coupon bond with a face-value of one dollar, which we see is no longer trivial. In fact, we make the rather startling discovery that such a claim is actually an equity derivative, in the setting of the bond price bubble. Its pricing function and delta are presented below, and are plotted in Fig. 4: Example 8 The pricing function Z : [0, T ) × (0, ∞) → (0, ∞) for a zero-coupon bond is given by 1 S = 1 − 2Φ − √ Z(t, S) := S Et,S , (33) ST T −t for all (t, S) ∈ [0, T ) × (0, ∞), by an application of (5). The associated replicating portfolio is determined by the delta ΔZ : [0, T ) × (0, ∞) → R of the zero-coupon bond, which is given by 2 ∂Z S Z (t, S) = √ ϕ √ , (34) Δ (t, S) := ∂S T −t T −t for all (t, S) ∈ [0, T ) × (0, ∞). Figure 4 reveals that the price of the bond is only significantly less than its (discounted) principal—which would have been its price if an equivalent risk-neutral probability measure existed—when the price of the risky security is low. The reason for this can be found in (1b), which reveals that when the price of the risky security is small, its drift rate explodes, resulting in a strong repulsion from the origin. Under these circumstances the risky security is an extremely attractive investment, since it generates a positive return over a short period of time, with a high degree of certainty. By comparison, the zero-coupon bond is relatively unattractive under these conditions, unless it trades at a price substantially lower than its discounted face-value. This explains why the price of the zero-coupon bond vanishes as the price of the risky security approaches zero.

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Fig. 4 The pricing function and the delta of a zero-coupon bond (T = 1)

It is also interesting to analyze the zero-coupon bond from the perspective of its replicating strategy. The surface plot of the delta of this instrument in Fig. 4 indicates that, at any fixed time before maturity, its replicating portfolio becomes progressively more heavily invested in the risky security as the price of that asset decreases. Once again, this simply takes advantage of the strong growth in the price of the risky security when it is low. In particular, (34) yields lim ΔZ (t, S) = √ S↓0

2 , 2π(T − t)

for all t ∈ [0, T ). An interesting consequence of this is that when maturity is imminent and the price of the risky security is close to zero, the certain principal payment of the zero-coupon bond can be hedged by purchasing an arbitrarily large number of units of the risky security. In other words, over short periods the price of the risky security exhibits growth that is almost deterministic, if its initial value is close to zero. This can be exploited to produce a non-random payoff at very low cost. We have already pointed out that the bond price bubble does not admit an equivalent risk-neutral probability measure, from which it follows that this model does not satisfy the NFLVR condition, by the results of [5]. As we shall now demonstrate, Example 8 allows us to establish the failure of NFLVR explicitly. To do so, consider a portfolio comprising a long position in the zero-coupon bond, which is funded by borrowing Z(0, S0 ) from the money-market account. The initial value of this portfolio is obviously zero, but its payoff at maturity is S0 > 0, Z(T , ST ) − Z(0, S0 ) = 2Φ − √ T by (33). Moreover, since Z(t, St ) > 0, for all t ∈ [0, T ], it follows that the value of this portfolio is uniformly bounded from below by −Z(0, S0 ). In other words, the portfolio described above violates what [14] refer to as the “true no-arbitrage property,” which is in fact a weaker condition than NFLVR.


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In Sect. 3 we saw that a prepaid forward contract on the risky security is nontrivial, in the case of the stock price bubble. The opposite is true for the bond price bubble, as demonstrated below: Example 9 The pricing function F : [0, T ) × (0, ∞) → (0, ∞) for a prepaid forward on the risky security is given by ST = S, (35) F(t, S) := S Et,S ST for all (t, S) ∈ [0, T ) × (0, ∞). The associated replicating portfolio is determined by the delta ΔF : [0, T ) × (0, ∞) → R of the contract, which is given by ΔF (t, S) :=

∂F (t, S) = 1, ∂S

(36)

for all (t, S) ∈ [0, T ) × (0, ∞). The next instrument we consider is a European call on the risky security. Its pricing function and delta are presented below, and are plotted in Fig. 5: Example 10 The pricing function C : [0, T ) × (0, ∞) → (0, ∞) for a European call on the risky security is given by (ST − K)+ 1 = S Pt,S (ST > K) − KS Et,S 1{ST >K} C(t, S) := S Et,S ST ST S−K S +K = (S − K)Φ √ + (S + K)Φ − √ T −t T −t √ S +K S−K −ϕ √ , (37) + T −t ϕ √ T −t T −t for all (t, S) ∈ [0, T ) × (0, ∞), by an application of (6) and (8). The associated replicating portfolio is determined by the delta ΔC : [0, T ) × (0, ∞) → R of the call, which is given by S −K ∂C S +K ΔC (t, S) := (t, S) = Φ √ + Φ −√ , (38) ∂S T −t T −t for all (t, S) ∈ [0, T ) × (0, ∞). By inspecting Fig. 5 we see that the price of the call and its delta behave quite conventionally, when compared with European calls in the Black-Scholes model, for example. In particular, the call price preserves the convexity of its payoff function, with respect to the price of the underlying risky security, at all times prior to maturity. Also, contrary to what we observed for the case of the stock price bubble, we see that the call price is an unbounded function of the price of the risky security, at any fixed time prior to maturity.

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Fig. 5 The pricing function and the delta of a call on the risky security (T = 1 and K = 1)

The delta of the call behaves as one would expect, for large values of risky security price, by converging to one. In other words, the replicating portfolio for the call is almost completely invested in the risky security when the contract is deep in-the-money. However, the behaviour of the call delta is a little unusual when the price of the risky security is very low. In particular, we obtain the following from (38): K C lim Δ (t, S) = 2Φ − √ , S↓0 T −t for all t ∈ [0, T ). In other words, at any fixed time before to maturity, the replicating portfolio for the call always holds at least a minimal number of units of the risky security. Once again, this phenomenon is explained by the strong growth of the price of the risky security when it is small. By comparison, under the assumptions of the Black-Scholes model, for example, the price of the risky security does not exhibit such growth behaviour near the origin, and the delta of a European call converges to zero as the price of the underlying asset becomes very small. To complete this section, we finally consider a European put on the risky security. Its pricing function and delta are presented below, and are plotted in Fig. 6. Example 11 The pricing function P : [0, T ) × (0, ∞) → (0, ∞) for a European put on the risky security is given by

(K − ST )+ 1 = KS Et,S 1{ST ≤K} − S Pt,S (ST ≤ K) P(t, S) := S Et,S ST ST S −K S +K S = (S − K)Φ √ − (S + K)Φ √ + 2KΦ √ T −t T −t T −t √ S +K S −K , (39) −ϕ √ + T −t ϕ √ T −t T −t


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Fig. 6 The pricing function and the delta of a put on the risky security (T = 1 and K = 1)

for all (t, S) ∈ [0, T ) × (0, ∞), by an application of (6) and (8). The associated replicating portfolio is determined by the delta ΔP : [0, T ) × (0, ∞) → R of the put, which is given by ∂P (t, S) ∂S S −K S+K 2K S =Φ √ −Φ √ +√ , ϕ √ T −t T −t T −t T −t

ΔP (t, S) :=

(40)

for all (t, S) ∈ [0, T ) × (0, ∞). Figure 6 reveals that the put option shares some of the strange features of the zero-coupon bond, discussed earlier in this section. In particular, we observe that the put price converges to zero as the price of the risky security decreases, for any fixed time before maturity. Once again, there is a sound economic explanation for this phenomenon, which takes into account the behaviour of the risky security price near zero. In detail, since the drift term in (1b) explodes near the origin, an almost certain profit can be earned in a short time by investing in the risky security when its price is very low. Due to its bounded payoff structure, the put therefore becomes unattractive relative to an investment in the risky security, when the price of the latter is very low. Another feature of the put, which is clearly visible from the surface plot of its pricing function in Fig. 6, is the fact that its price does not preserve the convexity of its payoff, with respect to the underlying risky security price, at any fixed time prior to maturity. This non-convexity is also observable in the surface plot of the put delta, where we see that the second derivative of the put price with respect to the price of the risky security is negative, for small enough prices of the risky security.

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In addition to the above, the expression (40) for the delta of the put reveals the following anomaly as well: 2K K P +√ lim Δ (t, S) = 1 − 2Φ √ S↓0 2π(T − t) T −t

√K 2K 1 T −t ϕ(ζ ) dζ + √ =1−2 + 2 2π(T − t) 0

√K T −t ϕ(0) − ϕ(ζ ) dζ > 0, =2 0

for all t ∈ [0, T ), by virtue of the fact that ϕ(ζ ) ≤ ϕ(0) = √1 , for all ζ ∈ R. This 2π tells us that the replicating portfolio for the put option contains a long position in the risky security, if the price of the latter is very low. In other words, a long position in the risky security may be required to hedge a contract whose payoff is negatively related to the price of the risky security at maturity! In fact, as we see from the surface plot of the put delta in Fig. 6, when the price of the risky security is very low and maturity is imminent, then a very long position in the risky security may be required replicate the put. The explanation for this apparent contradiction is to be found, once more, in the strong growth of the risky security price near the origin. Finally, it is easily verified that the pricing functions derived in this section are all related via the put-call parity relationship (32) proposed in Sect. 3. The fact that this identity holds for the stock price bubble and the bond price bubble (as well as for models where all local martingales are martingales) supports our claim that it is the proper formulation of put-call parity.

References 1. Abramowitz, M., Stegun, I.A. (eds.): Handbook of Mathematical Functions. Dover, New York (1972) 2. Becherer, D.: The numeraire portfolio for unbounded semimartingales. Finance Stoch. 5(3), 327–341 (2001) 3. Cox, A.M.G., Hobson, D.G.: Local martingales, bubbles and option prices. Finance Stoch. 9(4), 477–492 (2005) 4. Delbaen, F., Schachermayer, W.: Arbitrage and free lunch with bounded risk for unbounded continuous processes. Math. Finance 4(4), 343–348 (1994) 5. Delbaen, F., Schachermayer, W.: A general version of the fundamental theorem of asset pricing. Math. Ann. 300(3), 463–520 (1994) 6. Delbaen, F., Schachermayer, W.: Arbitrage possibilities in Bessel processes and their relations to local martingales. Probab. Theory Relat. Fields 102(3), 357–366 (1995) 7. Ekström, E., Tysk, J.: Bubbles, convexity and the Black-Scholes equation. Ann. Appl. Probab. 19(4), 1369–1384 (2009) 8. Elworthy, K.D., Li, X.M., Yor, M.: The importance of strictly local martingales; applications to radial Ornstein-Uhlenbeck processes. Probab. Theory Relat. Fields 115(3), 325–355 (1999) 9. Heston, S.L., Loewenstein, M., Willard, G.A.: Options and bubbles. Rev. Financ. Stud. 20(2), 359–389 (2007)


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10. Janson, S., Tysk, J.: Feynman-Kac formulas for Black-Scholes-type operators. Bull. Lond. Math. Soc. 38(2), 269–282 (2006) 11. Jarrow, R.A., Protter, P., Shimbo, K.: Asset price bubbles in complete markets. In: Fu, M.C., Jarrow, R.A., Yen, J.Y.J., Elliott, R.J. (eds.) Advances in Mathematical Finance, pp. 97–121. Birkhäuser, Boston (2007) 12. Jarrow, R.A., Protter, P., Shimbo, K.: Asset price bubbles in incomplete markets. Johnson School Research Paper Series No. 03-07, Cornell University (2007) 13. Jawitz, J.W.: Moments of truncated continuous univariate distributions. Adv. Water Resour. 27(3), 269–281 (2004) 14. Kabanov, Y., Stricker, C.: Remarks on the true no-arbitrage property. In: Séminaire de Probabilités XXXVIII. Lecture Notes in Mathematics, vol. 1857, pp. 186–194. Springer, Berlin (2004) 15. Karatzas, I., Kardaras, C.: The numéraire portfolio in semimartingale financial models. Finance Stoch. 11(4), 447–493 (2007) 16. Lebedev, N.N.: Special Functions and Their Applications. Dover, New York (1972) 17. Platen, E., Heath, D.: A Benchmark Approach to Quantitative Finance. Springer, Berlin (2006) 18. Revuz, D., Yor, M.: Continuous Martingales and Brownian Motion, 3rd edn. Springer, Berlin (1999)

A Remarkable σ -finite Measure Associated with Last Passage Times and Penalisation Problems Joseph Najnudel and Ashkan Nikeghbali

Abstract In this paper, we give a global view of the results we have obtained in relation with a remarkable class of submartingales, called (Σ), and which are stated in (Najnudel and Nikeghbali, 0906.1782 (2009), 0910.4959 (2009), 0911.2571 (2009) and 0911.4365 (2009)). More precisely, we associate to a given submartingale in this class (Σ), defined on a filtered probability space (Ω, F , P, (Ft )t≥0 ), satisfying some technical conditions, a σ -finite measure Q on (Ω, F ), such that for all t ≥ 0, and for all events Λt ∈ Ft : Q[Λt , g ≤ t] = EP [1Λt Xt ] where g is the last hitting time of zero of the process X. This measure Q has already been defined in several particular cases, some of them are involved in the study of Brownian penalisation, and others are related with problems in mathematical finance. More precisely, the existence of Q in the general case solves a problem stated by D. Madan, B. Roynette and M. Yor, in a paper studying the link between Black-Scholes formula and last passage times of certain submartingales. Once the measure Q is constructed, we define a family of nonnegative martingales, corresponding to the local densities (with respect to P) of the finite measures which are absolutely continuous with respect to Q. We study in detail the relation between Q and this class of martingales, and we deduce a decomposition of any nonnegative martingale into three parts, corresponding to the decomposition of finite measures on (Ω, F ) as the sum of three measures, such that the first one is absolutely continuous with respect to P, the second one is absolutely continuous with respect to Q and the third one is singular with respect to P and Q. This decomposition can be generalized to supermartingales. Moreover, if under P, the process (Xt )t≥0 is J. Najnudel · A. Nikeghbali () Institut für Mathematik, Universität Zürich, Winterthurerstrasse 190, 8057 Zürich, Switzerland e-mail: [email protected] J. Najnudel e-mail: [email protected] C. Chiarella, A. Novikov (eds.), Contemporary Quantitative Finance, DOI 10.1007/978-3-642-03479-4_5, © Springer-Verlag Berlin Heidelberg 2010

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a diffusion satisfying some technical conditions, one can state a penalisation result involving the measure Q, and generalizing a theorem given in (Najnudel et al., A Global View of Brownian Penalisations, 2009). Now, in the construction of the measure Q, we encounter the following problem: if (Ω, F , (Ft )t≥0 , P) is a filtered probability space satisfying the usual assumptions, then it is usually not possible to extend to F∞ (the σ -algebra generated by (Ft )t≥0 ) a coherent family of probability measures (Qt ) indexed by t ≥ 0, each of them being defined on Ft . That is why we must not assume the usual assumptions in our case. On the other hand, the usual assumptions are crucial in order to obtain the existence of regular versions of paths (typically adapted and continuous or adapted and càdlàg versions) for most stochastic processes of interest, such as the local time of the standard Brownian motion, stochastic integrals, etc. In order to fix this problem, we introduce another augmentation of filtrations, intermediate between the right continuity and the usual conditions, and call it N-augmentation in this paper. This augmentation has also been considered by Bichteler (Stochastic integration and stochastic differential equations, 2002). Most of the important results of the theory of stochastic processes which are generally proved under the usual augmentation still hold under the Naugmentation; moreover this new augmentation allows the extension of a coherent family of probability measures whenever this is possible with the original filtration.

1 Notation In this paper, (Ω, F , (Ft )t≥0 , P) will denote a filtered probability space. C (R+ , R) is the space of continuous functions from R+ to R. D(R+ , R) is the space of càdlàg functions from R+ to R. If Y is a random variable, we denote indifferently by P[Y ] or by EP [Y ] the expectation of Y with respect to P.

2 Introduction This paper reviews some recent results obtained by Cheridito, Nikeghbali and Platen [4] and by the authors of this paper [9–12] on the last zero of some remarkable stochastic processes and its relation with a universal σ -finite measure which has many remarkable properties and which seems to be in many places the key object to interpret in a unified way results which do not seem to be related at first sight. The last zero of càdlàg and adapted processes will play an essential role in our discussions: this fact is quite surprising since such a random time is not a stopping time and hence falls outside the domain of applications of the classical theorems in stochastic analysis. The problem originally came from a paper of Madan, Roynette and Yor [8] on the pricing of European put options where they are able to represent the price of a European put option in terms of the probability distribution of some last passage time. More precisely, they prove that if (Mt )t≥0 is a continuous nonnegative local

A Remarkable σ -finite Measure

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martingale defined on a filtered probability space (Ω, F , (Ft )t≥0 , P) satisfying the usual assumptions, and such that limt→∞ Mt = 0, then (K − Mt )+ = KP(gK ≤ t|Ft )

(1)

where K ≥ 0 is a constant and gK = sup{t ≥ 0 : Mt = K}. Formula (1) tells that it is enough to know the terminal value of the submartingale (K − Mt )+ and its last zero gK to reconstruct it. Yet a nicer interpretation of (1) is suggested in [8]: there exists a measure Q, a random time g, such that the submartingale Xt = (K − Mt )+ satisfies Q Ft 1g≤t = E [Ft Xt ] , (2) for any t ≥ 0 and for any bounded Ft -measurable random variable Ft . Indeed, it easily follows from (1) that, in this case, Q = K.P and g = gK . It is also clear that if a stochastic process X satisfies (2), then it is a submartingale. The problem of finding the class of submartingales which satisfy (2) is posed in [8]: Problem 1 ([8]) For which nonnegative submartingales X can we find a σ -finite measure Q and the end of an optional set g such that Q Ft 1g≤t = E [Ft Xt ]?

(3)

It is also noticed in [8] that other instances of (2) have already been discovered: for example, in [2], Azéma and Yor proved that for any continuous and uniformly integrable martingale M, (3) holds for Xt = |Mt |, Q = |M∞ |.P and g = sup{t ≥ 0 : Mt = 0}, or equivalently |Mt | = E[|M∞ |1g≤t |Ft ]. Here again the measure Q is finite. Recently, another particular case where the measure Q is not finite was obtained by Najnudel, Roynette and Yor in their study of Brownian penalisation (see [13]). They prove the existence of the measure Q when Xt = |Yt | is the absolute value of the canonical process (Yt )t≥0 under the Wiener measure W, on the space C (R+ , R) equipped with the filtration generated by the canonical process. In this case, the measure Q, which we shall denote hereafter W to remind we are working on the Wiener space, is not finite but σ -finite and is singular with respect to the Wiener measure: it satisfies W (g = ∞) = 0, where g = sup{t ≥ 0 : Xt = 0}. However, a closer look at this last example reveals that Problem 1 may lead to some paradox. Indeed, the existence of the measure Q implies that the filtration (Ft )t≥0 should not satisfy the usual assumptions. Indeed, if this were the case, then for all t ≥ 0, the event {g > t} would have probability one (under W) and then, would be in F0 and, a fortiori, in Ft . If one assumes that W exists, this implies: W [g > t, g ≤ t] = EW [1g>t Xt ],

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and then EW [Xt ] = 0, which is absurd. But now, if one does not complete the original probability space, then it is possible to show (see Sect. 3) that there does not exist a continuous and adapted version of the local time for the Wiener process Y , which is one of the key processes in the study of Brownian penalisations! More generally, one cannot apply most of the useful results from the general theory of stochastic processes such as the existence of càdlàg versions for martingales, the Doob-Meyer decomposition, the début theorem, etc. Consequently, one has to provide conditions on the underlying filtered probability space (Ω, F , (Ft )t≥0 , P) under which not only (3) in Problem 1 can hold, but also under which the existence of regular versions (e.g. continuous and adapted version for the Brownian local time) of stochastic processes of interest do exist: Problem 2 What are the natural conditions to impose to (Ω, F , (Ft )t≥0 , P) in order to have (3) and at the same time the existence of regular versions for stochastic processes of interest? In fact we shall see that the existence of the measure Q is related to the problem of extension of a coherent family of probability measures: given a coherent family of probability measures (Qt )t≥0 with Qt defined on Ft (i.e.: the restriction of Qt to F s is Qs for t ≥ s), does there exist a probability measure Q∞ defined on F∞ = t≥0 Ft such that the restriction of Q∞ to Ft is Qt ? The solution to such extension problems is well-known and very well detailed in the book by Parthasarathy [15], however, it is surprising that such a fundamental problem (if one thinks about the widely used changes of probability measures which are only locally absolutely continuous with respect to a reference probability measure) has rarely been considered together with the existence of càdlàg versions for martingales, the Doob-Meyer decomposition, the début theorem, etc. In Sect. 3, we shall propose an alternative augmentation of filtrations, intermediate between the right-continuous version and the usual augmentation, under which most of the properties generally proved under usual conditions (existence of càdlàg versions, existence of Doob-Meyer decomposition, etc.) are preserved, but for which it is still possible to extend compatible families of probability measures. We proposed this augmentation in [9] and discovered later than Bichteler has also proposed it in his book [3]. By using this augmentation, we are able to prove the existence of the measure Q under very general assumptions. The relevant class of submartingales is called (Σ), and the precise conditions under which we can show that Q exists are stated in Sect. 4. Just before this statement, we give a detailed solution of Problem 1 in the particular case where Q is absolutely continuous with respect to P, with some applications to financial modeling. The measure Q has some remarkable properties which we shall detail in Sect. 5. One of its most striking properties is that it allows a unified treatment of many problems of penalisation on the Wiener space which do not seem to be related at


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first sight. The framework which is generally used it the following (see the book [13] for more details and references): we consider W, the Wiener measure on C (R+ , R), endowed with its natural filtration (Fs )s≥0 , (Γt )t≥0 a family of nonnegative random variables on the same space, such that 0 < W[Γt ] < ∞, and for t ≥ 0, the probability measure Qt :=

Γt .W. W[Γt ]

Under these assumptions, Roynette, Vallois and Yor have proven (see [16]) that for many examples of family of functionals (Γt )t≥0 , there exists a probability measure Q∞ which can be considered as the weak limit of (Qt )t≥0 when t goes to infinity, in the following sense: for all s ≥ 0 and for all bounded, Fs -measurable random variables Fs , one has Qt [Fs ] −→ Q∞ [Fs ]. t→∞

For example, the measure Q∞ exists for the following families of functionals1 (Γt )t≥0 : • Γt = φ(Lt ), where (Lt )t≥0 is the local time at zero of the canonical process X, and φ is a nonnegative, integrable function from R+ to R+ . • Γt = φ(St ), where St is the supremum of X on the interval [0, t], and φ is, again, a nonnegative, integrable function from R+ to R+ . • Γt = eλLt +μ|Xt | , where (Lt )t≥0 is, again, the local time at zero of X. In [13], Najnudel, Roynette and Yor obtain a result which gives the existence of Q∞ for a large class of families of functionals (Γt )t≥0 . The proof of this penalisation result involves, in an essential way, the σ -finite measure W on the space C (R+ , R) described above. More precisely, they prove that for a relatively large class of functionals (Γt )t≥0 , Q∞ =

Γ∞ .W , W [Γ∞ ]

(4)

where Γ∞ is the limit of Γt when t goes to infinity, which is supposed to exist everywhere. Problem 3 Can we use our general existence theorem on the measure Q in Sect. 4 to extend the general result on the Brownian penalisation problem and W to a larger class of stochastic processes? 1 The discussion around Problem 2 shows that the results described below

are not correct because a continuous and adapted version of the Brownian local time does not exist with the natural filtration. The conditions given in Sect. 3 will remedy this gap.

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At end of Sect. 5, we shall see that the answer to Problem 3 is positive (which extends (4)), if under P, the submartingale (Xt )t≥0 is a diffusion satisfying some technical conditions. In particular, our result can be applied to suitable powers of Bessel processes if the dimension is in the interval (0, 2) (which includes the case of the reflected Brownian motion). Unlike all our other results, for which we are able to get rid of the Markov and scaling properties that have been used so far in the Brownian studies, the Markov property plays here a crucial role.

3 A New Kind of Augmentation of Filtrations Consistent with the Problem of Extension of Measures The discussion in this section follows closely our paper [9]; in particular the proofs which are not provided can be found there.

3.1 Understanding the Problem In stochastic analysis, most of the interesting properties of continuous time random processes cannot be established if one does not assume that their trajectories satisfy some regularity conditions. For example, a nonnegative càdlàg martingale converges almost surely, but if the càdlàg assumption is removed, the result becomes false in general. Recall a very simple counter-example: on the filtered probability space (C (R+ , R), F , (Ft )t≥0 , W), where Ft = σ {Xs , 0 ≤ s ≤ t}, F = σ {Xs , s ≥ 0}, (Xs )s≥0 is the canonical process and W the Wiener measure, the martingale Mt := 1Xt =1 t≥0 , which is a.s. equal to zero for each fixed t ≥ 0, does not converge at infinity. That is the reason why one generally considers a càdlàg version of a martingale. However there are fundamental examples of stochastic processes for which such a version does not exist. Indeed let us define on the filtered probability space (C (R+ , R), F , (Ft )t≥0 , W) described above, the stochastic process (Lt )t≥0 as follows: t Lt = Φ lim inf fm (Xs )ds , m→∞

0

where fm denotes the density of a centered Gaussian variable with variance 1/m and Φ is the function from R+ ∪ {∞} to R+ such that Φ(x) = x for x < ∞ and Φ(∞) = 0. The process (Lt )t≥0 is a version of the local time of the canonical process at level zero, which is defined everywhere and (Ft )t≥0 -adapted. It is known that the process: Mt := |Xt | − Lt t≥0


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is an (Ft )t≥0 -martingale. However, (Mt )t≥0 does not admit a càdlàg version which is adapted. In other words, there exists no càdlàg, adapted version (Lt )t≥0 for the local time at level zero of the canonical process! This property can be proved in the following way: let us consider an Ornstein-Uhlenbeck process (Ut )t≥0 , starting from zero, and let us define the process (Vt )t≥0 by: Vt = (1 − t)Ut/(1−t) for t < 1, and Vt = 0 for t ≥ 1. This process is a.s. continuous: we denote by Q its distribution. One can check the following properties: • For all t ∈ [0, 1), the restriction of Q to Ft is absolutely continuous with respect to the corresponding restriction of W. • Under Q, Lt → ∞ a.s. when t → 1, t < 1. By the second property, the set {Lt −→ ∞} has probability one under Q. Since t→1,t 0, which is a contradiction. Therefore, the usual conditions are not suitable for the problem of extension of coherent probability measures. In fact one can ob , but serve that the argument above does not depend on the completeness of F

only on the fact that F0 contains all the sets in F of probability zero. That is why it still remains available if we consider, with the notation above, the space (C (R+ , R), F , (Ft )t≥0 , W), where for all t ≥ 0, Ft is the σ -algebra generated by Ft and the sets in F of probability zero.

3.2 The N-usual Augmentation In order to make compatible the general results on the extension of probability measures problem and the existence of regular versions for stochastic processes, we propose an augmentation which is intermediate between right continuity and the usual


85

augmentation, and we call it the N-augmentation. As already mentioned, Bichteler has introduced this augmentation before us in his book [3], and has called it the natural augmentation. But when we discovered this augmentation, we were not aware of Bichteler’s work and this is reflected in the difference in our approaches. Hence the interested reader would benefit by looking at both [3] and [9]. Definition 1 ([9]) Let (Ω, F , (Ft )t≥0 , P) be a filtered probability space. A subset A of Ω is N-negligible with respect to the space (Ω, F , (Ft )t≥0 , P), iff there exists a sequence (Bn )n≥0 of subsets of Ω, such that for all n ≥ 0, Bn ∈ Fn , P[Bn ] = 0, and A⊂ Bn . n≥0

Remark 1 The integers do not play a crucial rôle in Definition 1. If (tn )n≥0 is an unbounded sequence in R+ , one can replace the condition Bn ∈ Fn by the condition Bn ∈ Ftn . Let us now define a notion which is the analog of completeness for N-negligible sets. It is the main ingredient in the definition of what we shall call the N-usual conditions: Definition 2 ([9]) A filtered probability space (Ω, F , (Ft )t≥0 , P), is N-complete if and only if all the N-negligible sets of this space are contained in F0 . It satisfies the N-usual conditions if and only if it is N-complete and the filtration (Ft )t≥0 is right-continuous. It is natural to ask if from a given filtered probability space, one can define in a canonical way a space which satisfies the N-usual conditions and which is as “close” as possible to the initial space. The answer to this question is positive in the following sense: Proposition 1 ([9]) Let (Ω, F , (Ft )t≥0 , P) be a filtered probability space, and N

be the σ -algebra generated by N and F , the family of its N-negligible sets. Let F

and for all t ≥ 0, Ft the σ -algebra generated by N and Ft+ , where Ft . Ft+ := u>t

) which coincides with Then there exists a unique probability measure P on (Ω, F

, (F

t )t≥0 , P on F , and the space (Ω, F P) satisfies the N-usual conditions. Moreover, if (Ω, F , (Ft )t≥0 , P ) is a filtered probability space satisfying the N-usual conditions, such that F contains F , Ft contains Ft for all t ≥ 0, and if P

, F contains F

t , for all t ≥ 0 and is an extension of P, then F contains F t

, (F

t )t≥0 , P is an extension of P. In other words, (Ω, F P) is the smallest extension of (Ω, F , (Ft )t≥0 , P) which satisfies the N-usual conditions: we call it the N-augmentation of (Ω, F , (Ft )t≥0 , P).

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Once the N-usual conditions are defined, it is natural to compare them with the usual conditions. One has the following result: Proposition 2 Let (Ω, F , (Ft )t≥0 , P) be a filtered probability space which satisfies the N-usual conditions. Then for all t ≥ 0, the space (Ω, Ft , (Fs )0≤s≤t , P) satisfies the usual conditions. Proof The right-continuity of (Fs )0≤s≤t is obvious, let us prove the completeness. If A is a negligible set of (Ω, Ft , P), there exists B ∈ Ft , such that A ⊂ B and P[B] = 0. One deduces immediately that A is N-negligible with respect to (Ω, F , (Ft )t≥0 , P), and by N-completeness of this filtered probability space, A ∈ F0 . This relation between the usual conditions and the N-usual conditions is the main ingredient to prove that one can replace the usual conditions by the N-usual conditions in most of the classical results in stochastic calculus. For example, the following can be proved: • If (Xt ) is a martingale, then it admits a càdlàg modification, which is unique up to indistinguishability. • If (Ω, F , (Ft )t≥0 , P) is a filtered probability space satisfying the N-usual conditions, and if (Xt )t≥0 is an adapted process defined on this space such that there exists a càdlàg version (resp. continuous version) (Yt )t≥0 of (Xt )t≥0 , then there exists a càdlàg and adapted version (resp. continuous and adapted version) of (Xt )t≥0 , which is necessarily indistinguishable from (Yt )t≥0 . • Let (Ω, F , (Ft )t≥0 , P) be a filtered probability space satisfying the N-usual conditions, and let A be a progressive subset of R+ × Ω. Then the début of A, i.e. the random time D(A) such that for all ω ∈ Ω: D(A)(ω) := inf{t ≥ 0, (t, ω) ∈ A} is an (Ft )t≥0 -stopping time. • Let (Xt )t≥0 be a right-continuous submartingale defined on a filtered probability space (Ω, F , (Ft )t≥0 , P), satisfying the N-usual conditions. We suppose that (Xt )t≥0 is of class (DL), i.e. for all a ≥ 0, (XT )T ∈Ta is uniformly integrable, where Ta is the family of the (Ft )t≥0 -stopping times which are bounded by a (for example, every nonnegative submartingale is of class (DL)). Then, there exist a right-continuous (Ft )t≥0 -martingale (Mt )t≥0 and an increasing process (At )t≥0 starting at zero, such that: Xt = Mt + At for all t ≥ 0, and for every bounded, right-continuous martingale (ξs )s≥0 , E [ξt At ] = E ξs− dAs , (0,t]


87

where ξs− is the left-limit of ξ at s, almost surely well-defined for all s > 0. The processes (Mt )t≥0 and (At )t≥0 are uniquely determined, up to indistinguishability. Moreover, they can be chosen to be continuous if (Xt )t≥0 is a continuous process. • The section theorem holds in a filtered probability space satisfying the N-usual assumptions and hence optional projections are well-defined.

3.3 Extension of Measures and the N-usual Augmentation We first state a well-known Parthasarathy type condition for the probability measures extension problem. Definition 3 Let (Ω, F , (Ft )t≥0 ) be a filtered measurable space, such that F is the σ -algebra generated by Ft , t ≥ 0: F = t≥0 Ft . We shall say that the property (P) holds if and only if (Ft )t≥0 enjoys the following conditions: • For all t ≥ 0, Ft is generated by a countable number of sets; • For all t ≥ 0, there exist a Polish space Ωt , and a surjective map πt from Ω to Ωt , such that Ft is the σ -algebra of the inverse images, by πt , of Borel sets in Ωt , and such that for all B ∈ Ft , ω ∈ Ω, πt (ω) ∈ πt (B) implies ω ∈ B; • If (ωn )n≥0 is a sequence of elements of Ω, such that for all N ≥ 0, N

An (ωn ) = ∅,

n=0

where An (ωn ) is the intersection of the sets in Fn containing ωn , then: ∞

An (ωn ) = ∅.

n=0

Given this technical definition, one can state the following result: Proposition 3 ([9, 15]) Let (Ω, F , (Ft )t≥0 ) be a filtered measurable space satisfying the property (P), and let, for t ≥ 0, Qt be a probability measure on (Ω, Ft ), such that for all t ≥ s ≥ 0, Qs is the restriction of Qt to Fs . Then, there exists a unique measure Q on (Ω, F ) such that for all t ≥ 0, its restriction to Ft is equal to Qt . One can easily deduce the following corollary which is often used in practice: Corollary 1 Let Ω be C (R+ , Rd ), the space of continuous functions from R+ to Rd , or D(R+ , Rd ), the space of càdlàg functions from R+ to Rd (for some d ≥ 1). For t ≥ 0, define (Ft )t≥0 as the natural filtration of the canonical process Y , and F = t≥0 Ft . Then (Ω, F , (Ft )t≥0 ) satisfies property (P).

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Proof Let us prove this result for càdlàg functions (for continuous functions, the result is similar and proved in [17]). For all t ≥ 0, Ft is generated by the variables Yrt , for r, rational, in [0, 1], hence, it is countably generated. For the second property, one can take for Ωt , the set of càdlàg functions from [0, t] to Rd , and for πt , the restriction to the interval [0, t]. The space Ωt is Polish if one endows it with the Skorokhod metric. Moreover, its Borel σ -algebra is equal to the σ -algebra generated by the coordinates, a result from which one easily deduces the properties of πt which need to be satisfied. The third property is easy to check: let us suppose that (ωn )n≥0 is a sequence of elements of Ω, such that for all N ≥ 0, N

An (ωn ) = ∅,

n=0

where An (ωn ) is the intersection of the sets in Fn containing ωn . Here, An (ωn ) is the set of functions ω which coincide with ωn on [0, n]. Moreover, for n ≤ n , integers, the intersection of An (ωn ) and An (ωn ) is not empty, and then ωn and ωn

coincide on [0, n]. Therefore, there exists a càdlàg function ω which coincides with ωn on [0, n], for all n, which implies: ∞

An (ωn ) = ∅.

n=0

Remark 2 It is easily seen that the conditions of Proposition 3 are not satisfied by the space C ([0, 1], R) endowed with the filtration (Ft )t≥0 , where Ft is the σ -algebra generated by the canonical process up to time t/(1 + t). An explicit counterexample is provided in [7]. The next proposition shows how condition (P) combines with the N-usual augmentation: Proposition 4 ([9]) Let (Ω, F , (Ft )t≥0 , P) be the N-augmentation of a filtered probability space satisfying the property (P). Then if (Qt )t≥0 is a coherent family of probability measures, Qt defined on Ft , and absolutely continuous with respect to the restriction of P to Ft , there exists a unique probability measure Q on F which coincides with Qt on Ft , for all t ≥ 0.

4 A Universal σ -finite Measure Q 4.1 The Class (Σ) We now have all the ingredients to rigorously answer Problem 1 raised in the Introduction. For this we will first need to introduce a special class of local submartin-


89

gales which was first introduced by Yor [18] and further studied by Nikeghbali [14] and Cheridito, Nikeghbali and Platen [4]. Definition 4 Let (Ω, F , (Ft )t≥0 , P) be a filtered probability space. A nonnegative (local) submartingale (Xt )t≥0 is of class (Σ), if it can be decomposed as Xt = Nt + At where (Nt )t≥0 and (At )t≥0 are (Ft )t≥0 -adapted processes satisfying the following assumptions: • (Nt )t≥0 is a càdlàg (local) martingale. • (At )t≥0 is a continuous increasing process, with A0 = 0. • The measure (dAt ) is carried by the set {t ≥ 0, Xt = 0}. We shall say that (Xt )t≥0 is of class (ΣD) if X is of class (Σ) and of class (D). The class (Σ) contains many well-known examples of stochastic processes (see e.g. [14]) such as nonnegative local martingales, |Mt |, Mt+ , Mt− if M is a continuous local martingale, the drawdown process St − Mt where M is a local martingale with t only negative jumps and St = supu≤t Mu , the relative drawdown process 1 − M St if M0 = 0, the age process of the standard Brownian motion Wt in the filtration of the √ zeros of the Brownian motion, namely t − gt , where gt = sup{u ≤ t : Wu = 0}, etc. Moreover one notes that if X is of (Σ), then Xt + Mt is also of class (Σ) for any strictly positive càdlàg local martingale M. Another key property of the class (Σ) is the following stability result which follows from an application of Ito’s formula and a monotone class argument. Proposition 5 ([14]) Let (Xt )t≥0 be of class (Σ) and let f : R → R be a locally bounded Borel function. Let us further assume that (Ω, xF , (Ft )t≥0 , P) satisfies the usual assumptions or is N-complete. Denote F (x) = 0 f (y)dy. Then the process (f (At )Xt )t≥0 is again of class (Σ) with decomposition: t f (Au )dNu + F (At ). (5) f (At )Xt = f (0)X0 + 0

4.2 A Special Case Related to Financial Modeling Now we state a theorem which gives sufficient conditions under which a process of the class (Σ) which converges to X∞ a.s. satisfies (3). This result is an extension of a result by Azéma-Yor [2] and Azéma-Meyer-Yor [1]. Indeed, in the case when X is of class (ΣD), one could deduce it from part 1 of Theorem 8.1 in [1]. The proof is very simple in this case and we give it. Theorem 1 ([4]) Assume that (Ω, F , (Ft )t≥0 , P) satisfies the usual assumptions or is N-complete. Let (Xt )t≥0 be a process of class (Σ) such that limt→∞ Xt = X∞ exists a.s. and is finite (in particular N∞ and A∞ exist and are a.s. finite). Let g := sup{t : Xt = 0} with the convention sup ∅ = 0.

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1. If (Xt )t≥0 is of class (D), then XT = E[X∞ 1{g≤T } | FT ]

for every stopping time T .

(6)

2. More generally, if there exists a strictly positive Borel function f such that (f (At )Xt )t≥0 is of class (D), then (6) holds. 3. If (Nt+ )t≥0 is of class (D), then (6) holds. Proof (1) For a given stopping time T , denote dT = inf{t > T : Xt = 0} with the convention inf ∅ = ∞. One checks that dT is a stopping time. Since X∞ 1{g≤T } = XdT and AT = AdT , it follows from Doob’s optional stopping theorem that E[X∞ 1{g≤T } | FT ] = E[NdT + AdT | FT ] = E[NdT + AT | FT ] = NT + AT = XT . (2) Assume that there exists a strictly positive Borel function such that (f (At )Xt )t≥0 is of class (D). This property is preserved if one replaces f by a smaller strictly positive Borel function, hence, one can suppose that f is locally bounded. Then (f (At )Xt )t≥0 is of class (ΣD), and from part (1) of the theorem, we have: f (AT )XT = E[f (A∞ )X∞ 1{g≤T } | FT ]. But on the set {g ≤ T }, we have A∞ = AT , and consequently f (AT )XT = f (AT )E[X∞ 1{g≤T } | FT ]. The result follows by dividing both sides by f (AT ) which is strictly positive. (3) Since X ≥ 0 and since (Nt+ )t≥0 is of class (D), we note that (exp(−At )Xt )t≥0 is of class (D) and the result follows from (2). The above theorem is used in [4] for financial applications. For example, if (Mt )t≥0 is a nonnegative local martingale, converging to 0 (which is a reasonable model for stock prices or for portfolios under the benchmark approach), then the drawdown process DDt = maxu≤t Mu − Mt is of class (Σ) as well as the relative t . For example, if (Mt )t≥0 is a strict nondrawdown process rDDt = 1 − maxM u≤t Mu negative local martingale such as the inverse of the 3 dimensional Bessel process, then (DDt )t≥0 is of class (Σ), satisfies condition (3) of the above theorem but is not uniformly integrable. Note that Theorem 1 applies in this case, even if the local martingale part of the process (DDt )t≥0 , which is equal to (−Mt )t≥0 , is not a true martingale.

4.3 The General Case A general solution for Problem 1 is provided in [12]; the measure W is a special case of this theorem. For the general case, we need to be very careful: the theorem


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below would be wrong under the usual assumptions and it would also be wrong if the filtration (Ft )t≥0 does not allow the extension of coherent probability measures. The N-usual assumptions are here to ensure in particular that there exists a continuous and adapted version of the process A which is defined everywhere (think of At being for example the local time at the level 0 of the Wiener process). According to Sect. 3, typical probability spaces where the following theorem holds are C (R+ , R) and D(R+ , R). Theorem 2 Let (Xt )t≥0 be a true submartingale of the class (Σ): its local martingale part (Nt )t≥0 is a true martingale, and Xt is integrable for all t ≥ 0. We suppose that (Xt )t≥0 is defined on a filtered probability space (Ω, F , P, (Ft )t≥0 ) satisfying the property (NP), in particular, this space satisfies the N-usual conditions and F is the σ -algebra generated by Ft for t ≥ 0. Then, there exists a unique σ -finite measure Q, defined on (Ω, F , P), such that for g := sup{t ≥ 0, Xt = 0}: • Q[g = ∞] = 0; • For all t ≥ 0, and for all Ft -measurable, bounded random variables Γt , Q Γt 1g≤t = P [Γt Xt ] . In [12], the measure Q is explicitly constructed, in the following way (with a slightly different notation). Let f be a Borel, integrable, strictly positive and bounded function from R to R, and let us define the function G by the formula: ∞ G(x) = f (y) dy. x

One can prove that the process f Mt := G(At ) − EP [G(A∞ )|Ft ] + f (At )Xt

t≥0

,

(7)

is a martingale with respect to P and the filtration (Ft )t≥0 . Since (Ω, F , P, (Ft )t≥0 ) satisfies the N-usual conditions and since G(At ) ≥ G(A∞ ), one can suppose that this martingale is nonnegative and càdlàg, by choosing carefully the version of EP [G(A∞ )|Ft ]. In this case, since (Ω, F , P, (Ft )t≥0 ) satisfies the property (NP), there exists a unique finite measure M f such that for all t ≥ 0, and for all bounded, Ft -measurable functionals Γt : f

M f [Γt ] = EP [Γt Mt ]. Now, since f is strictly positive, one can define a σ -finite measure Q f by: Q f :=

1 .M f . f (A∞ )

It is proved is [12] that if the function G/f is uniformly bounded (this condition is, for example, satisfied for f (x) = e−x ), then Q f satisfies the conditions defining

92


Q in Theorem 2, which implies the existence part of this result. The uniqueness part is proved just after in a very easy way: one remarkable consequence of it is the fact that Q f does not depend on the choice of f . The measure Q has many other interesting properties, which will be detailed in Sect. 5.

5 Further Properties of Q and Some Remarkable Associated Martingales, and Penalisation Results The properties of Q given in this section are stated and proved in [11], except the results concerning penalisation, which are shown in [10]. By the construction of Q described above, it is clear that if f is a Borel, integrable, strictly positive and bounded function from R to R, and if, with the notation above, G/f is uniformly bounded, then M f = f (A∞ ) .Q.

(8)

f

Now, by using (7), it is possible to construct (Mt )t≥0 , and then M f , for all Borel, integrable and nonnegative functions f . Moreover, it is proved in [11] that (8) remains true for any function f satisfying these weaker assumptions. The relation f between the functional f (A∞ ) and the martingale (Mt )t≥0 can be generalized as follows: Proposition 6 We suppose that the assumptions of Theorem 2 hold, and we take the same notation. Let F be a Q-integrable, nonnegative functional defined on (Ω, F ). Then, there exists a càdlàg P-martingale (Mt (F ))t≥0 such that the measure M F := F.Q is the unique finite measure satisfying, for all t ≥ 0, and for all bounded, Ft measurable functionals Γt : M F [Γt ] = P[Γt Mt (F )]. The martingale (Mt (F ))t≥0 is unique up to indistinguishability. If f is Borel, integrable and nonnegative, then f (A∞ ) is integrable with respect to Q and one has f

Mt (f (A∞ )) = Mt , which gives an explicit expression for Mt (f (A∞ )). This explicit form can be generalized to the martingale (Mt (F ))t≥0 for all nonnegative and Q-integrable functionals F , if the submartingale (Xt )t≥0 is uniformly integrable. More precisely, one has the following result: Proposition 7 Let us suppose that the assumptions of Theorem 2 are satisfied, and that the process (Xt )t≥0 is uniformly integrable. Then, Xt tends a.s. to a limit X∞ when t goes to infinity, and the measure Q is absolutely continuous with respect to P, with density X∞ . Moreover, a nonnegative functional F is integrable with respect


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to Q if and only if F X∞ is integrable with respect to P, in this case, (Mt (F ))t≥0 a the càdlàg version of the conditional expectation (P[F X∞ |Ft ])t≥0 . In particular, it is uniformly integrable, and it converges a.s. and in L1 to F X∞ when t goes to infinity. A more interesting case is when we suppose that A∞ is infinite, P-almost surely. From now, until the end of this section, we always implicitly make this assumption (which is satisfied, in particular, if (Xt )t≥0 is a reflected Brownian motion). The following result gives the asymptotic behaviour of (Xt )t≥0 under Q, when t goes to infinity, and the behaviour of Mt (F ), which is not the same under P and under Q: Proposition 8 Let us suppose that the assumptions of Theorem 2 are satisfied, and that A∞ = ∞, P-almost surely. Then, Q-almost everywhere, Xt tends to infinity when t goes to infinity, and for all nonnegative, Q-integrable functionals F , the martingale (Mt (F ))t≥0 tends P-almost surely to zero and Q-almost everywhere to infinity. Moreover, one has: Mt (F ) −→ F, Xt t→∞ Q-almost everywhere. By definition, the martingales of the form (Mt (F ))t≥0 are exactly the local densities of the finite measures which are absolutely continuous with respect to Q. This situation is similar to the case of uniformly integrable, nonnegative martingales, which are local densities of finite measures, absolutely continuous with respect to P. The following decomposition of nonnegative supermartingales, already proved in [13] in the case of the reflected Brownian motion, involves simultaneously these two kind of martingales: Proposition 9 Let us suppose that the assumptions of Theorem 2 are satisfied, and that A∞ = ∞, P-almost surely. Let Z be a nonnegative, càdlàg P-supermartingale. We denote by Z∞ the P-almost sure limit of Zt when t goes to infinity. Then, Qalmost everywhere, the quotient Zt /Xt is well-defined for t large enough and converges, when t goes to infinity, to a limit z∞ , integrable with respect to Q, and (Zt )t≥0 decomposes as (Zt = Mt (z∞ ) + P[Z∞ |Ft ] + ξt )t≥0 , where (P[Z∞ |Ft ])t≥0 denotes a càdlàg version of the conditional expectation of Z∞ with respect to Ft , and (ξt )t≥0 is a nonnegative, càdlàg P-supermartingale, such that: • Z∞ ∈ L1+ (F , P), hence P[Z∞ |Ft ] converges P-almost surely and in L1 (F , P) towards Z∞ . |Ft ]+ξt −→ 0, Q-almost everywhere. • P[Z∞X t t→∞

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• Mt (z∞ ) + ξt −→ 0, P-almost surely. t→∞

be a QMoreover, the decomposition is unique in the following sense: let z∞

integrable, nonnegative functional, Z∞ a P-integrable, nonnegative random variable, (ξt )t≥0 a càdlàg, nonnegative P-supermartingale, and let us suppose that for all t ≥ 0,

Zt = Mt (z∞ ) + P[Z∞ |Ft ] + ξt .

Under these assumptions, if for t going to infinity, ξt tends P-almost surely to zero

= z , Q-almost everyand ξt /Xt tends Q-almost everywhere to zero, then z∞ ∞

where, Z∞ = Z∞ , P-almost surely, and ξ is P-indistinguishable with ξ . This result implies the following characterisation of martingales of the form (Mt (F ))t≥0 : Corollary 2 Let us suppose that the assumptions of Theorem 2 are satisfied, and that A∞ = ∞, P-almost surely. Then, a càdlàg, nonnegative P-martingale (Zt )t≥0 is of the form (Mt (F ))t≥0 for a nonnegative, Q-integrable functional F , if and only if: Zt P[Z0 ] = Q lim . (9) t→∞ Xt Note that, by Proposition 9, the limit above necessarily exists Q-almost everywhere. If in Proposition 9, (Zt )t≥0 is a nonnegative martingale, the corresponding decomposition can be interpreted as a Radon-Nykodym decomposition of finite measures. Indeed, let us observe that since the space satisfies the property (NP), there exists a unique finite measure QZ on (Ω, F ), such that for all t ≥ 0, its restriction to Ft has density Zt with respect to P. If one writes the decomposition Zt = Mt (z∞ ) + P[Z∞ |Ft ] + ξt , one deduces: QZ = z∞ .Q + Z∞ .P + Qξ , where the restriction of Qξ to Ft has density ξt with respect to P. In [11], it is proved that Qξ is singular with respect to P and Q, hence one has a decomposition of QZ into three parts: • A part which is absolutely continuous with respect to P. • A part which is absolutely continuous with respect to Q. • A part which is singular with respect to P and Q. This decomposition is unique, as a consequence of the uniqueness of the RadonNykodym decomposition. Another interesting problem is to find a relation between the measure Q and the last passage times of (Xt )t≥0 at a given level, which can be different from zero. The following result proves this relation when (Xt )t≥0 is continuous:


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Proposition 10 Let us suppose that the assumptions of Theorem 2 are satisfied, the submartingale (Xt )t≥0 is continuous and A∞ = ∞ almost surely under P. For a ≥ 0, let g [a] be the last hitting time of the interval [0, a]: g [a] = sup{t ≥ 0, Xt ≤ a}. Then, the measure Q satisfies the following formula, available for any t ≥ 0, and for all Ft -measurable, bounded variables Γt : Q Γt 1g [a] ≤t = P Γt (Xt − a)+ . (10) Moreover, ((Xt − a)+ )t≥0 is a submartingale of class (Σ) and the σ -finite measure obtained by applying Theorem 2 to it is equal to Q. The relation between the measure Q and the last hitting time of a given level a is one of the main ingredients of the proof of our penalisation result stated below. Since we are able to show this statement only when (Xt )t≥0 is a diffusion satisfying some technical conditions, let us give another result, strongly related to penalisations, but available under more general assumptions: Proposition 11 Let us suppose that the assumptions of Theorem 2 are satisfied, and A∞ = ∞, P-almost surely. Let (Ft )t≥0 be a càdlàg, adapted, nonnegative, nonincreasing and uniformly bounded process, such that for some a > 0, one has for all t ≥ 0, Xt = Xg [a] on the set {t ≥ g [a] }. Then, if Fg is Q-integrable, and if one defines F∞ as the limit of Ft for t going to infinity (in particular, F∞ = Fg [a] for g [a] < ∞), one has: P[Ft Xt ] −→ Q[F∞ ]. t→∞

In [11], there are another version of this result, with slightly different assumptions. In order to obtain a penalisation result, we need to estimate the expectation of Ft under P, instead of the expectation of Ft Xt . This gives an extra factor, depending on t, in the asymptotics, which justifies some restriction on the process (Xt )t≥0 . Let us now describe the precise framework which is considered. We define Ω as the space of continuous functions from R+ to R+ , (Ft0 )t≥0 as the natural filtration of Ω, and F 0 , as the σ -algebra generated by (Ft0 )t≥0 . The probability P0 , defined on (Ω, F 0 ), satisfies the following condition: under P0 , the canonical process is a recurrent diffusion in natural scale, starting from a fixed point x0 ≥ 0, with zero as an instantaneously reflecting barrier, and such that its speed measure is absolutely continuous with respect to Lebesgue measure on R+ , with a density m : R∗+ → R∗+ , continuous, and such that m(x) is equivalent to cx β when x goes to infinity, for some c > 0 and β > −1. Moreover, we suppose that there exists C > 0 such that for all x > 0, m(x) ≤ Cx β if β ≤ 0, and m(x) ≤ C(1 + x β ) if β > 0. Let us now define the filtered probability space (Ω, F , (Ft )t≥0 , P) as the N-augmentation of (Ω, F 0 , (Ft0 )t≥0 , P0 ): (Ω, F , (Ft )t≥0 , P) satisfies property (NP) and under P, the law of the canonical process is a diffusion with the same parameters as under

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P0 . This diffusion is in natural scale, and one can deduce from this fact and the assumptions above that the canonical process (Xt )t≥0 is a submartingale of class (Σ). In particular, Xt is integrable for all t ≥ 0. Moreover, the local time (Lt )t≥0 of (Xt )t≥0 at level zero, is its increasing process. One deduces that Theorem 2 applies, which defines the corresponding measure Q, and we can check that we are in the situation where L∞ = ∞, P-almost surely. Under these assumptions, we can prove the following result: Proposition 12 Let (Ft )t≥0 be a càdlàg, adapted, nonnegative, uniformly bounded and nonincreasing process. We assume that there exists a > 0 such that for all t ≥ 0, Xt = Xg [a] on the set {t ≥ g [a] }, we define F∞ as the limit of Ft for t going to infinity, and we suppose that F∞ is integrable with respect to Q. Then, there exists D > 0 such that for all s ≥ 0 and for all events Λs ∈ Fs : t 1/(β+2) P[Ft 1Λs ] −→ D Q[F∞ 1Λs ]. t→∞

The following penalisation result is a straightforward consequence of Proposition 12: Proposition 13 Let (Ft )t≥0 be a càdlàg, adapted, nonnegative, uniformly bounded and nonincreasing process. We assume that there exists a > 0 such that for all t ≥ 0, Xt = Xg [a] on the set {t ≥ g [a] }, we define F∞ as the limit of Ft for t going to infinity, and we suppose that 0 < Q[F∞ ] < ∞. Then, for all t ≥ 0: 0 < P[Ft ] < ∞, and one can then define a probability measure Qt on (Ω, F ) by Qt :=

Ft .P. P[Ft ]

Moreover, the probability measure: Q∞ :=

F∞ .Q Q[F∞ ]

is the weak limit of Qt in the sense of penalisations, i.e. for all s ≥ 0, and for all events Λs ∈ Fs , Qt [Λs ] −→ Q∞ [Λs ]. t→∞

This penalisation result applies, in particular, to the power 2r of a Bessel process of dimension 2(1 − r), for any r ∈ (0, 1) (in this case, the parameter β is equal to (1/r) − 2). For r = 1, (Xt )t≥0 is a reflected Brownian motion, and our result is very similar to the penalisation theorem stated in [13] for the Brownian motion.


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References 1. Azéma, J., Meyer, P.-A., Yor, M.: Martingales relatives. In: Séminaire de Probabilités, XXVI. Lecture Notes in Math., vol. 1526, pp. 307–321. Springer, Berlin (1992) 2. Azéma, J., Yor, M.: Sur les zéros des martingales continues. In: Séminaire de Probabilités, XXVI. Lecture Notes in Math., vol. 1526, pp. 248–306. Springer, Berlin (1992) 3. Bichteler, K.: Stochastic Integration and Stochastic Differential Equations. Encyclopedia of Mathematics and its Applications. Cambridge University Press, Cambridge (2002) 4. Cheridito, P., Nikeghbali, A., Platen, E.: Processes of the class sigma, last zero and draw-down processes (2009) 5. Dellacherie, C., Meyer, P.-A.: Probabilité et Potentiel, vol. I. Hermann, Paris (1976) 6. Dellacherie, C., Meyer, P.-A.: Probabilité et Potentiel, vol. II. Hermann, Paris (1980) 7. Föllmer, H., Imkeller, P.: Anticipation cancelled by a Girsanov transformation: A paradox on Wiener space. Ann. Inst. Henri Poincaré Probab. Stat. 29(4), 569–586 (1993) 8. Madan, D., Roynette, B., Yor, M.: From Black-Scholes formula, to local times and last passage times for certain submartingales. Prépublication IECN, No. 14 (2008) 9. Najnudel, J., Nikeghbali, A.: A new kind of augmentation of filtrations. 0910.4959 (2009) 10. Najnudel, J., Nikeghbali, A.: On penalisation results related with a remarkable class of submartingales. 0911.4365 (2009) 11. Najnudel, J., Nikeghbali, A.: On some properties of a universal sigma-finite measure associated with a remarkable class of submartingales. 0911.2571 (2009) 12. Najnudel, J., Nikeghbali, A.: On some universal σ -finite measures and some extensions of Doob’s optional stopping theorem. 0906.1782 (2009) 13. Najnudel, J., Roynette, B., Yor, M.: A Global View of Brownian Penalisations. MSJ Memoirs 19. Mathematical Society of Japan, Tokyo (2009) 14. Nikeghbali, A.: A class of remarkable submartingales. Stoch. Process. Appl. 116(6), 917–938 (2006) 15. Parthasarathy, K.-R.: Probability Measures on Metric Spaces. Academic Press, New York (1967) 16. Roynette, B., Vallois, P., Yor, M.: Some penalisations of the Wiener measure. Jpn. J. Math. 1(1), 263–290 (2006) 17. Stroock, D.-W., Varadhan, S.-R.-S.: Multidimensional Diffusion Processes. Classics in Mathematics. Reprint of the 1997 edition. Springer, Berlin (2006) 18. Yor, M.: Les inégalités de sous-martingales, comme conséquences de la relation de domination. Stochastics 3(1), 1–15 (1979)

Pricing Without Equivalent Martingale Measures Under Complete and Incomplete Observation Giorgia Galesso and Wolfgang J. Runggaldier

Abstract Traditional arbitrage pricing theory is based on martingale measures. Recent studies show that there are situations when there does not exist an equivalent martingale measure and so the question arises: what can one do with pricing and hedging in this situation? We mention here two approaches to this effect that have appeared in the literature, namely the “Fernholz-Karatzas” approach and Platen’s “Benchmark approach” and discuss their relationships both in models where all relevant quantities are fully observable as well as in models where this is not the case and, furthermore, not all observables are also investment instruments.

1 Introduction Traditional arbitrage pricing theory is based on martingale measures, whereby the density process as well as the prices expressed in units of a same numeraire are martingales. Recent studies such as [1, 2] show that some form of arbitrage may exist in real markets and then processes, which in traditional theory are martingales, turn out to be strictly local martingales. Without necessarily passing through absence of arbitrage, also the authors of [5] describe instances in which classical martingale processes are strict local martingales. Typically such a process is the density process and then no equivalent martingale measure exists. In such a situation the question arises: what can one do with pricing and hedging? This issue has already been dealt with in the literature and, after recalling the basic features of two of these approaches, our first purpose in the paper is to show that, although based on different viewpoints, they lead to the same values for the prices in W.J. Runggaldier () · G. Galesso Department of Pure and Applied Mathematics, University of Padova, 63, Via Trieste, I-35121 Padova, Italy e-mail: [email protected] G. Galesso e-mail: [email protected] C. Chiarella, A. Novikov (eds.), Contemporary Quantitative Finance, DOI 10.1007/978-3-642-03479-4_6, © Springer-Verlag Berlin Heidelberg 2010

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G. Galesso and W.J. Runggaldier

the case when all relevant quantities are fully observable. The second purpose is to extend the two approaches to situations when some of the underlying quantities of the market model are not fully observable and, furthermore, not all observables are also investment instruments and to compare the two approaches also in this latter case. The first approach is based on work mainly done by E.R. Fernholz and I. Karatzas together with co-workers and of which an overview is given in [2]. We shall refer to it as “Fernholz-Karatzas (FK) approach”. The basic idea here is taken from a classical approach in incomplete markets whereby the price of a derivative asset is defined as the smallest superreplicating initial capital. By utilizing the exponential (local) martingale given by the density process Z(·), it is shown that this price can be obtained by utilizing Z(·) B(·) as “deflator” (B(t) is the money market account/local riskless asset). In this context it is also shown that, even without existence of a martingale measure, the market can be completed and a hedging strategy is explicitly exhibited. The second approach is based on work done by E. Platen and coworkers and a comprehensive account can be found in the book [5]. Platen calls it the “Benchmark approach” and we shall refer to it under this same name with the acronym (PB). Here the methodology is based on utility indifference pricing thereby showing that the resulting price is independent of the chosen utility function as well as of the initial wealth and it does not require the claim to be replicable. By showing, in this paper, the equivalence of the two approaches in the case of complete observation we also show that, although by (PB) the claim does not have a priori to be replicable, it is so a posteriori and a replicating strategy is given by the one constructed in the (FK) approach. Since the (FK) approach relies on completing the market, while (PB) is of the utility indifference pricing type that is typically designed for incomplete markets, it appears to be rather intuitive that (FK) has to be restricted to those situations where all observables are also investment instruments. In fact we show that, while in the complete observation case the two approaches are equivalent, there are some differences in the case of incomplete observation if not all observables are also investment instruments. We consider a classical diffusion type model, although extensions to discontinuous market models may be envisaged. A major role in both approaches is plaid by the growth optimal portfolio (GOP) and we briefly summarize some of its basic features. We also discuss the relationship between the (GOP) strategy and growth rate under complete and incomplete observation. We always assume however that the value of the GOP is observable (possibly via a proxy). We start in Sect. 2 by describing the model and deriving the GOP. Section 3 is a brief account on how some form of classical arbitrage may arise implying that then an equivalent martingale measure does not exist. It is based on [2], further instances may be found in [5]. In Sect. 4 we summarize the basic features of the two approaches, adding some detail to the proofs of the main results and showing their equivalence under full observation of all relevant quantities. In Sect. 5 we first describe the incomplete observation model that is based on [7] and where, furthermore,

Pricing Without Martingale Measures Under Complete and Incomplete Observation

101

not all observables are also investment instruments and discuss some consequences for the GOP and utility maximization. Then we describe extensions of the two approaches to this model and discuss a possible equivalence.

2 The Model We consider a market M with a locally riskless asset and a certain number n of risky assets with prices B(t) and Si (t) respectively that, on a given filtered probability space (Ω, F , F (t), P ), satisfy the following diffusion-type model dB(t) = B(t)r(t)dt,

B(0) = 1,

dSi (t) = Si (t) bi (t)dt +

n

σij (t)dwj (t) ,

(1) Si (0) = si > 0, i = 1, . . . , n.

j =1

We assume the number of driving Wiener processes wj (t) to be equal to the number of risky assets and that the diffusion matrix σ (t) = {σij (t)}i,j =1,...,n is non singular for each t ∈ [0, T ] with T < ∞. Furthermore, the coefficients in (1) are progressively measurable and satisfy T n T n 2 |r(t)|dt + (σij (t)) dt < ∞ a.s. for any T ∈ (0, ∞). |bi (t)| + 0

i=1 0

j =1

(2) While for most of the results below the filtration {F (t)} can be fully general, for some of them we shall, without much loss of generality, assume that F (t) = F w (t). From (1) we obtain for the risky assets’ log prices d log Si (t) = γi (t)dt +

n

σij (t)dwj (t),

i = 1, . . . , n

(3)

j =1

with 1 γi (t) := bi (t) − aii (t), a(t) = σ σ (t), i = 1, . . . , n. 2 Under controlled growth of a(t) as e.g. log log T T a (t)dt = 0, a.s. i = 1, . . . , n lim ii T →∞ T2 0 one has

T 1 log Si (T ) − γi (t)dt = 0 T →∞ T 0 lim

which justifies the definition of γi (t) as growth rate of the i-th asset.

(4)

(5)

(6)

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A portfolio strategy (investment rates) is a progressively measurable process π(t) = (π1 (t), . . . , πn (t)) with values in

(π1 , . . . , πn ) ∈ R | π1 + · · · + πn ≤ 1, π12 + · · · + πn2 ≤ k 2 . k∈N

The ratio 1 − ni=1 πi (t) is invested in the risk-free asset. Let V v,π (t) be the value at t of a self financing portfolio with V v,π (0) = v. From the self financing condition one then has n n dB(t) dSi (t) dV v,π (t) π (t) πi (t) = 1 − + i V v,π (t) B(t) Si (t) i=1 i=1 ⎛ ⎞ n n n = 1− πi (t) r(t)dt + πi (t) ⎝bi (t)dt + σij (t)dwj (t)⎠ . i=1

Putting σπj (t) :=

j =1

i=1

(7)

n

i=1 πi (t)σij (t),

d log V v,π (t) = γπ (t)dt +

we have, analogously to (3) and (4),

n

σπj (t)dwj (t),

i = 1, . . . , n

(8)

j =1

with the portfolio growth rate γπ (t) = r(t) +

n j =1

2 n 1 σπj (t)θj (t) − σπj (t) 2

(9)

j =1

where, in vector notation, θ (t) := (σ (t))−1 (b(t) − r(t)1)

(10)

is the “market price of risk”. Under a controlled growth of a(t) analogous to (5), also here one has T 1 log V v,π (T ) − lim γπ (t)dt = 0, (11) T →∞ T 0 justifying again the name “growth rate” and notice that V v,π = vV 1,π := vV π . This latter scaling property of V allows us to derive most of the results for the simpler V π , they will then hold automatically also for V v,π for any v > 0. Definition 1 Given an initial wealth v, the set of admissible strategies is H (v) := T >0 H (v; T ) where

H (v; T ) := π(·) | P V v,π (t) ≥ 0, ∀ 0 ≤ t ≤ T = 1 . (12) A major role is plaid by the so-called growth optimal portfolio (GOP) that maximizes the growth rate among the admissible portfolios (it maximizes also the expected log-utility).


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In vector form we have for the growth rate for a generic portfolio π 1 γπ (t) = r(t) + π (t)σ (t)θ (t) − π (t)σ σ (t)π(t) 2 which is a concave function of π so that, denoting by ρ(t) the GOP strategy that maximizes this growth rate, one has ρ(t) = (σ (t))−1 θ (t).

(13)

From (8) and (9) we have for any admissible π dV π (t) = r(t)dt + π (t)σ (t) θ (t)dt + dw(t) V π (t) which implies for π = ρ dV ρ (t) = r(t) + θ (t) 2 dt + θ (t)dw(t) V ρ (t) and so t t 1 t r(s)ds + θ (s) 2 ds + θ (s)dw(s) . V ρ (t) = exp 2 0 0 0

(14)

(15)

(16)

Furthermore, the growth rate of the GOP is 1 γρ (t) = r(t) + θ (t) 2 . 2

(17)

3 Relative Arbitrage and Absence of Martingale Measures Traditional arbitrage pricing theory is based on equivalent martingale measures. In particular, defining t 1 t θ (s) 2 ds , 0 ≤ t < ∞ Z(t) := exp − θ (s)dw(s) − (18) 2 0 0 with θ (t) as in (10), the following holds: if E{Z(T )} = 1 for any given T ∈ (0, ∞), then Z(t) is a mean one martingale and, defining a measure Q ∼ P with t dQ ˆ = w(t) + 0 θ (s)ds is a Wiener process on dP |F (T ) = Z(T ), one has that w(t) (Ω, F , F (t), Q) and S¯i (t) := B −1 (t)Si (t) are (F (t), Q)-martingales. There are however situations, and below we shall mention some instances, where E{Z(T )} < 1 for some T ∈ (0, ∞) and then there does not exist an equivalent martingale measure and the traditional pricing approach breaks down. In view of mentioning examples where E{Z(T )} < 1 let us give the following definition (see [2]) Definition 2 Given two portfolio strategies π(·) and ρ(·), we say that π(·) represents an arbitrage opportunity relative to ρ(·) on [0, T ] for T > 0 if, with V π (0) = V ρ (0), one has P(V π (T ) ≥ V ρ (T )) = 1 and P(V π (T ) > V ρ (T )) > 0.

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One can then show the following proposition (see again [2]) Proposition 1 If model (1) satisfies ξ (σ σ )(t)ξ ≤ K ξ 2 , ∀ξ ∈ Rn , ∀t ∈ [0, ∞) with K > 0 and for a T > 0 there exists an arbitrage relative to a given portfolio ρ(·), then Z(t) is a strictly local martingale and E{Z(T )} < 1. As a corollary one can show (see always [2]) Corollary 2 Under the assumptions of Proposition 1 and assuming F (t) = F w (t), there does not exist an equivalent martingale measure. In [2] it is shown how one can construct relative arbitrage also on arbitrary time horizons, which leads to one kind of examples where there does not exist an equivalent martingale measure. Other kinds of examples can be found in [5]. Since in the situations corresponding to the above examples the traditional pricing approach based on equivalent martingale measures breaks down, one may wonder what can be done in such situations for what concerns pricing and the rest of the paper is devoted to this issue.

4 Pricing Under Absence of an Equivalent Martingale Measure (the Case of Complete Observation) We summarize here two approaches and show that, although based on different viewpoints, they lead to the same prices.

4.1 The “Fernholz-Karatzas Approach” This subsection in based on [2]. The main idea here is taken from a classical approach in incomplete markets, whereby a reasonable way to assign a price to a derivative asset is to put it equal to the smallest initial amount needed to superreplicate a given claim with a self financing portfolio. The methodology is based on showing that, even without existence of a martingale measure, the market can be completed and here the proof is constructive by exhibiting a hedging strategy. One has the following theorem (see [2, 3]) Theorem 3 Consider a given maturity T and a claim Y ∈ F (T ) such that ) E{Y Z(T B(T ) } ∈ (0, ∞) with Z(t) as in (18). For t ∈ [0, T ], let

Ht (v; T ) := π(·) | P V v,π (s) ≥ 0, ∀ t ≤ s ≤ T = 1; V v,π (t) = v ∈ F (t)


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namely the set of admissible strategies starting from a capital v at time t and put

U Y (t) := ess inf v > 0 | ∃π ∈ Ht (v; T ) s.t. V v,π (T ) ≥ Y (19) which represents the minimal hedging price at time t. Let, furthermore, B(t) Z(T ) Y (t) := E Y | F (t) Z(t) B(T )

(20)

with the expectation under the physical measure P . If F (t) = F w (t), then Y (t) = U Y (t).

(21)

Remark 4 On the basis of this theorem we shall now take Y (t) as price of the claim at time t. Notice that in formula (20) the process Z(t) B(t) acts as a “deflator”. Notice furthermore that, if Z(t) is a true martingale and S is the set of martingale measures then, since U Y (t) is the minimal superhedging price, B(t) Y | F (t) Y (t) = U Y (t) = sup E Q B(T ) Q∈S namely the here defined price coincides with the standard superhedging price. Proof of Theorem 3 We proceed along several steps, whereby we shall also need the B(t) . fact that, as will be shown in Sect. 4.3 below, V ρ (t) = Z(t) (s) v,π (s), i) Notice first that from (14) and (15) we have for Vˆ v,π (s):= VV ρ (s) = Z(s) B(s) V with s ∈ [t, T ] and any v > 0, that (in vector form) v,π

d Vˆ v,π (s) = Vˆ v,π (s)(π (s)σ (s) − θ (s))dw(s)

(22)

so that Vˆ v,π is a non-negative local martingale and therefore a supermartingale with Vˆ v,π (t) = v (recall that V ρ (s) is the GOP with V ρ (t) = 1). Since, as will be shown in iii) below, the set in the definition of U Y (t) is not empty, then there exists π ∈ Ht (v; T ) such that V v,π (T ) ≥ Y and so Z(T ) B(t) B(t) Z(T ) E Y | F (t) ≤ E V v,π (T ) | F (t) Y (t) = Z(t) B(T ) Z(t) B(T ) B(t) v,π Z(t) V (t) =v ≤ Z(t) B(t) which implies Y (t) ≤ U Y (t). To complete the proof, in the next steps we show that Y (t) ≥ U Y (t) and we do it by explicitly constructing a hedging strategy. ii) Under the assumptions of the theorem we can define the (P , F (t))-martingale Z(T ) M(s) := E Y | F (s) (23) B(T )

106


which, given that F (t) = F w (t), admits the following “martingale representation” for s ∈ [t, T ], s s Z(t) M(s) = M(t) + ψ (u)dw(u) = Y (t) ψ (u)dw(u) (24) + B(t) t t for a progressively measurable, a.s. square integrable process ψ(t) and where the last equality follows from the definition of Y (t) in (20). iii) If we choose v such that Z(T ) v,π ˆ | F (t) v = V (t) = M(t) = E Y B(T ) and π such that d Vˆ v,π (s) = dM(s) for s ∈ [t, T ] then Vˆ v,π (s) = M(s) for all s ∈ [t, T ] and we have Z(T ) B(s) E Y | F (s) . V v,π (s) = V ρ (s)M(s) = Z(s) B(T ) This implies that

(25)

(26)

v = V v,π (t) = Y (t) V v,π (T ) = Y

i.e. the strategy π satisfying (25) is an admissible hedging strategy and this also implies that the set in the definition of U Y (t) is not empty and so Y (t) ≥ U Y (t). iv) It remains to explicitly exhibit an admissible strategy π satisfying (25). It suffices to equalize the coefficients of dw(t) in (22) and (24) namely, recalling that v,π (s) v,π (s) = M(s), to impose the following Vˆ v,π (s) := VV ρ (s) = Z(s) B(s) V Z(s) v,π V (s) π (s)σ (s) − θ (s) = ψ (s) B(s) which leads to π(s) = σ −1 (s)

ψ(s) + θ (s) M(s)

for s ∈ [t, T ] with t ∈ [0, T ].

(27)

4.2 The “Benchmark Approach” of Platen This subsection is based on [5]. Here the methodology builds on utility indifference pricing thereby showing that the resulting price is independent of the chosen utility function and of the initial wealth and it does not require the claim to be replicable.


107

To simplify the presentation, in what follows we shall denote with a “bar” the values expressed in units of the locally riskless asset, for example V¯ v,π (t) = B −1 (t)V v,π (t). We start with the following Definition 3 An asset or portfolio value expressed in units of the GOP is called benchmarked. A price or portfolio process is fair if its benchmarked value is a (Ft , P )-martingale. This definition corresponds to the property of a discounted self financing portfolio value process to be a martingale under any martingale measure, provided there exists one. Notice also that it is reasonable to restrict oneself to fair portfolios because they are martingales and a martingale is the smallest among the supermartingales that reach a same value at a future (stopping) time. Utility indifference pricing is based on expected utility maximization, which we recall next. Given a utility function U (·) and an initial capital v > 0, the utility maximization problem consists in determining an admissible strategy π˜ such that

(28) E U (V¯ v,π˜ (T )) ≥ E U (V¯ v,π (T )) ∀π ∈ H (v; T ). Here we want the strategies also to generate a fair portfolio process. A rather straightforward extension of the so-called “martingale approach” to utility maximization (see e.g. [8]), coupled with fairness of the corresponding portfolio process, leads to the following Lemma 5 Given a utility function U (·) and an initial wealth v > 0, the fair discounted terminal portfolio value solving (28) is given by λ v,π˜ −1 ˙ ¯ (29) V (T ) = U V¯ v,ρ (T ) where U˙ denotes the derivative of U , V¯ v,ρ (T ) is the discounted terminal value of the GOP and the (Lagrange) parameter λ is determined from the “budget equation” v,π˜ V v,π˜ (0) v V (T ) = v,ρ = = 1. (30) E v,ρ V (T ) V (0) v The strategy π˜ is any admissible strategy leading to the terminal portfolio value in (29). Remark 6 In the standard martingale approach, where the existence of martingale measure is given, the budget equation results from the martingality of the discounted value process of a self financing portfolio. Not assuming here the existence of a martingale measure, we impose the condition of fairness instead.

108


Sketch of the proof The budget equation (30) is a consequence of the requirement of fairness. Given the budget constraint, by the Lagrange multiplier method the problem becomes that of maximizing V v,π (T ) v,π ¯ . (31) E U (V (T )) − λ v,ρ V (T ) The “martingale approach” now consists in maximizing U (V¯ ) − λ

V

= U (V¯ ) − λ

V¯

(32) V v,ρ (T ) V¯ v,ρ (T ) with respect to V¯ that leads, for each “scenario” ω ∈ Ω, to the optimal terminal value V¯ v,π˜ (T ) given by (29). The strategy π˜ is then determined as the hedging strategy for the “claim” V¯ v,π˜ (T ). We come next to the actual utility indifference pricing. Given U (·) and the corresponding π˜ , it is well known that the utility indifference price P (t) at time t of a given claim Y is such that, defining V¯ v,π˜ (T ) v,π˜ ¯ | F (t) + ε Y := E U (V (t) − εP (t)) pε,P (t) V (t) where V (t) is the investor’s wealth at time t starting from v and following the strategy π˜ , one has lim

ε→0

v,π˜ v,π˜ pε,P (t) − p0,P (t)

ε

=0

a.s.

v,π˜ v,π˜ Using a Taylor expansion of pε,P (t) around p0,P (t) , it is easily seen that this leads to the following (see [5])

Proposition 7 Given U (·) and the corresponding π˜ , the utility indifference price is

E U˙ (V¯ v,π˜ (T ))Y¯ | F (t) , P (t) = (33) ¯ v,π˜ E U˙ (V¯ v,π˜ (T )) V V (t)(T ) | F (t) where, again, U˙ denotes the derivative of U . We can now show the following (see [3, 5]) Theorem 8 The utility indifference price is given by Y | F (t) P (t) = V ρ (t)E V ρ (T )

(34)

where V ρ (t) = V 1,ρ (t) is the portfolio value corresponding to the GOP strategy ρ. Proof Substituting (29) into (33) results in the following chain of equalities, where we use the fairness property of the benchmarked portfolio values


E

P (t) = E

Y V v,ρ (T )

| F (t)

V v,π˜ (T ) 1 V v,ρ (T ) V (t)

= | F (t)

V v,π˜ (t)E

Y V v,ρ (T )

109

| F (t)

V v,π˜ (t) V v,ρ (t)

Y ρ | F (t) = vV (t)E | F (t) = V (t)E V v,ρ (T ) vV ρ (T ) Y = V ρ (t)E | F (t) ρ V (T )

v,ρ

Y

whereby the Lagrange parameter as well as the initial wealth v have canceled out. Remark 9 Formula (34) corresponds to a standard arbitrage pricing formula, whereby one takes as numeraire the GOP and the resulting martingale measure is the physical measure P . It is thus an instance of the so-called “real world pricing”. In line with Definition 3 the price P (t) is a fair price. We stress once again that the pricing formula (34) is independent of the utility function U (·) and of the initial wealth v > 0 and does not require the existence of a martingale measure nor the claim to be a priori replicable. The claim will though turn out to be replicable a posteriori via the equivalence of the pricing approach of this Sect. 4.2 with that of the previous Sect. 4.1 that will be discussed next.

4.3 Equivalence of the Two Pricing Approaches Recall that, according to the pricing approach in Sect. 4.1, the (superhedging) price Y (t) at time t ∈ [0, T ] of a given claim Y with maturity T is given by (see (20)) Z(T ) B(t) E Y | F (t) Y (t) := Z(t) B(T ) and it corresponds to that of the standard martingale approach if Z(t) is a true martingale. On the other hand, the (utility indifference) price P (t) according to the approach in Sect. 4.2 is given by (see (34)) Y ρ P (t) = V (t)E | F (t) . V ρ (T ) We now show that the two pricing approaches lead to the same result by proving Proposition 10 One has Y (t) = P (t). Proof It suffices to show that V ρ (t) =

B(t) Z(t)

110


which is equivalent to showing that the discounted GOP value is the inverse of the “density process” Z(t) a fact that is generally known under standard assumptions. We show it here formally within our context. Recalling (16), namely t t 1 t V ρ (t) = exp r(s)ds + θ (s) 2 ds + θ (s)dw(s) 2 0 0 0 and noticing that from (18) one has t 1 t 2 θ (s) θ (s)dw(s) − ds exp − 0 2 0 Z(t) = t B(t) exp r(s)ds 0

t t 1 t 2 θ (s)dw(s) − θ (s) ds − r(s)ds , = exp − 2 0 0 0 the result follows immediately.

Remark 11 Notice that none of the two approaches, that in Sect. 4.1 and that in 4.2, requires the existence of an equivalent martingale measure. From the first approach it is easily seen that, if Z(t) is a martingale and therefore there exists an equivalent martingale measure, then the usual arbitrage (martingale-based) price coincides with that in Sect. 4.1 and, by the equivalence just shown, also with that in Sect. 4.2. The pricing formula in Sect. 4.2 and, by the equivalence, also that in Sect. 4.1, corresponds to that of a standard pricing approach by taking as numeraire the GOP, for which the physical measure is a martingale measure (this also justifies the fact that none of the two approaches required the existence of a martingale measure different from the physical measure P ). The approach in Sect. 4.2 does not require the claim to be a priori replicable. The constructive approach of Sect. 4.1, which is based on a replication argument and exhibits explicitly a replication strategy, implies, via the equivalence, that also in the approach of Sect. 4.2 the claim is in fact replicable. We finally want to point out that the equivalence of the two approaches is implicit in some parts of [5], for example in Sect. 11.5 where it is emphasized that “for a nonreplicable payoff the real world pricing formula provides the minimal nonnegative price process” or also in later sections like 12.2 where Fig. 12.2.4 is intended to “visualize the fact that fair prices are the minimal prices that replicate a contingent claim” and for this the authors refer to Corollary 10.4.2 (always in [5]).

5 Pricing Under Absence of an Equivalent Martingale Measure (the Case of Incomplete Observation) We now extend the results, summarized in the previous Sect. 4 for the case of complete observation on the market model, to a market model with incomplete observation. We first describe the model that we are considering.


111

5.1 The Model The model is taken from [7]. Consider the model (1) with one riskless asset and n risky assets and assume that the observable quantities are the n + 1 prices of the primary assets, the empirical covariances of the risky assets’ log-prices with that of the GOP (we assume that the values of the GOP or of a proxy thereof are observable) in addition to the short rate of interest r(t). To simplify the notation, in what follows we shall consider all the prices expressed in units of the riskless asset (discounted values) and, whenever ambiguity may arise, denote their values with a bar. Let C(t) = (C1 (t), . . . , C2n (t)) be the vector of observable (discounted) quantities (excluding the short rate). It is natural to assume that the underlying filtration F (t) measures C(t). Assume then that there are also a certain number of unobservable quantities, denote them by A(t) = (A1 (t), . . . , Am (t)) that we may think of as representing latent factors that affect the primary assets’ price dynamics. We restrict the volatility matrix σ (t) to depend only on the observable quantities and to stress this fact we shall write σ (t) = σ (t, C(t)) assuming furthermore that it is invertible for all t ≤ T < ∞. Recalling the market price of risk in (10), here we then write it as θ (t, A(t)) = (σ (t, C(t)))−1 (b(t, A(t)) − r(t)1)

(35)

to stress the dependence also on A(t) (it depends also on C(t) not only through σ (t, C(t)) but in general also through b(·) that is F (t)-measurable). In line with the above definitions we rewrite the dynamics of the discounted values of the risky assets as (see (1)) n σij (t, C(t))(θj (t, A(t))dt + dwj (t)) , S¯i (0) = si > 0 d S¯i (t) = S¯i (t) j =1

(36) and the discounted value process V¯ v,π (t) = v V¯ 1,π (t) = v V¯ π (t) of a self financing portfolio (that invests only in the risky assets) becomes (see (14)) d V¯ π (t) = π (t)σ (t, C(t)) [θ (t, A(t))dt + dw(t)] . V¯ π (t)

(37)

Finally, corresponding to (15) d V¯ ρ (t) = θ (t, A(t)) 2 + θ (t, A(t))dw(t). V¯ ρ (t)

(38)

Having assumed that also the empirical log-covariances are observable, we need a model for these quantities as well, and we shall represent them as noisy perturbations of the corresponding unobservable theoretical covariances.

112


Letting Δ denote the discrete time observation step and t := Δ the grid points of the observations, for the i-th log-covariance we have zi (t) = ln(S¯i ), ln(V¯ ρ ) Δ,t

t

Δ ln(S¯i (tl )) − ln(S¯i (tl−1 )) ln(V¯ ρ (tl )) − ln(V¯ ρ (tl−1 )) =

(39)

l=1

where [a] denotes the largest integer less than or equal to a. Putting D(t) = (D1 (t), . . . , D2n+m (t)) = (C1 (t), . . . , C2n (t), A1 (t), . . . , Am (t))

(40)

and Bi (t, D(t)) :=

n

σij (t, C(t))θj (t, A(t))

(41)

j =1

the i-th theoretical covariance is then t ! " Bi (s, D(s))ds. ln(S¯i ), ln(V¯ ρ ) t = ln(S¯i ), ln(V¯ ρ ) t =

(42)

0

Since the theoretical covariances are the limit in probability of the empirical covariances, we may postulate for the latter the following model dzi (t) = Bi (t, D(t))dt + dηi (t)

(43)

where ηi (t) are n independent Wiener processes, independent of the wj (t), and they represent the discrepancy between theoretical and empirical covariances.

5.2 Corresponding Complete Observation Model Since the unobservable factors are inputs to the model, also solutions of problems for the model will depend on them. On the other hand prices and strategies should only depend on the available information that results from the observations. In the following two subsections we shall show that, for our pricing problem, we can equivalently consider a complete observation problem corresponding to the original one under incomplete observation and in this equivalent problem all inputs are given by quantities that are all observable either directly or indirectly. In this subsection we now derive this equivalent complete observation problem, sometimes also referred to as “separated problem”. Put, with some abuse of notation (44) C(t) = S¯1 (t), . . . , S¯n (t), z1 (t), . . . , zn (t) that now represents the totality of the observable quantities and consider the 2ndimensional Wiener process W (t) = (w1 (t), . . . , wn (t), η1 (t), . . . , ηn (t)) .

(45)


113

Recalling (40) and (41) and putting B(t, D(t)) = (B1 (t, D(t)), . . . , Bn (t, D(t))) we obtain the following dynamics for the global 2n-dimensional vector C(t) ¯ ¯ diag (S(t)) B(t, D(t)) diag (S(t)) σ (t, C(t)) 0 dC(t) = dt + dW (t) B(t, D(t)) 0 I := F (t, D(t))dt + G(t, C(t))dW (t)

(46)

thereby implicitly defining the (vector) drift F (t, D) and (matrix) volatility G(t, C). The information filtration is the one generated by the k := 2n components of C(t) and to stress the “dimension” k of the observations we write F k (t) := σ {C(s), s ≤ t} .

(47)

As it is typically done in partial observation problems, we consider now instead of the unobservable quantities A(t) their conditional distribution (the so-called filter distribution) (48) p A(t) | F k (t) = p(A(t) | σ {C(s), s ≤ t}). We make the following Assumption 12 The filter for A(t) given F k (t) is finite-dimensional, namely the filter distribution p(A(t) | F k (t)) is parametrized by a finite number of parameters ξ(t) = ξ1 (t), . . . , ξq (t) . More precisely, p(A(t) | F k (t)) = p(A(t); ξ1 (t), . . . , ξq (t)) Remark 13 Well known finite dimensional filters are the Kalman-Bucy filter and the Wonham filter for the case when the unobserved quantities form a finite-state Markov chain. More generally, the Extended Kalman filter is a finite-dimensional filter that is applicable, modulo an approximation, to a variety of situations. In all the above cases the filter parameters form a Markov process driven by the innovations (for the definition of “innovations” see Remark 15 below). This, together with (46) motivates and also justifies the following additional assumption. Assumption 14 By analogy to (40) put ˜ D(t) = C1 (t), . . . , C2n (t), ξ1 (t), . . . , ξq (t)

(49)

that represents the extended (2n + q)-dimensional vector of “observables”. We assume that the parameters ξ(t) of the finite-dimensional filter satisfy ˜ ˜ dξ(t) = H (t, D(t))dt + K(t, D(t)) dC(t).

(50)

114


We now apply Theorem 7.12 in [4] (see also Proposition 2.3 in [6]) according to which the k = 2n-dimensional process C(t) satisfies, instead of (46) where the factor D(t) in the drift is not fully observable, the following dynamics ˜ dC(t) = F˜ (t, D(t))dt + G(t, C(t))d W˜ (t)

(51)

with ˜ F˜ (t, D(t)) = E{F (t, D(t)) | F k (t)} k = F (t, C(t), A)dp(A | F (t)) = F (t, C(t), A)dp(A; ξ1 , . . . , ξq ) (52) and where W˜ (t) is a k-dimensional F k -Wiener process (with independent components) satisfying ˜ d W˜ (t) = (G(t, C(t))−1 [dC(t) − F˜ (t, D(t))dt].

(53)

Remark 15 Due to the representation in (53), the process W˜ (t) is also called “innovations process” and notice that by this same (53), combined with (50), the dynamics of the finite-dimensional filter parameters ξ(t) can be expressed in terms of these innovations (see also the last part of Remark 13). Furthermore, from (51) and (53) ˜ and recalling the definition of F k (t) in (47), one has that F k (t) = F W (t), namely the observation filtration is equivalently generated by the innovations W˜ (t). Remark 16 In what follows we shall use the symbol w(t) ˜ to denote the ndimensional subvector of the k = 2n dimensional vector W˜ (t), which is formed by the first n components and which (see (51) and the definition of G(t, C) in (46)) satisfies −1 ¯ ¯ − B(t, ˜ D(t))dt ˜ d S(t) (54) d w(t) ˜ = (σ (t, C(t)))−1 diag S(t) ˜ where, by analogy to F˜ (t, D(t)) in (52), ˜ D(t)) ˜ B(t, = E B(t, D(t)) | F k (t) = B(t, C(t), A)dp(A | F k (t)) = B(t, C(t), A)dp(A; ξ1 , . . . , ξq ). (55) Combining (51) with (50), it is easily seen that, for appropriate coefficients α(·) and β(·) one obtains for the extended (2n + q)-dimensional observation vector dynamics of the form ˜ + d D˜ i (t) = αi (t, D(t))dt

2n

˜ βij (t, D(t))d W˜ j (t)

(56)

j =1

We shall next derive particularized dynamics, in terms of the innovations, for the (discounted) prices and the GOP.


115

5.2.1 Price Dynamics The (discounted) prices of the risky assets form (see (49) and (44)) the first n com˜ ponents of D(t) and their dynamics are affected only by the first n components of ˜ W (t), the vector of which we had denoted by w(t). ˜ Recalling then (41) and (46) as well as (51), one obtains for the discounted asset prices n # $ ˜ σij (t, C(t)) θ˜j (t, D(t))dt + d w˜ j (t) , S¯i (0) = si > 0 d S¯i (t) = S¯i (t) j =1

(57) where

k ˜ ˜θj (t, D(t)) = E θj (t, A(t)) | F (t) = θj (t, A)dp(A; ξ1 , . . . , ξq ). (58)

(Recall from the comment after (35) that θ (t, A(t)) hides a possible dependence also on C(t).) Notice that joining (56) to (57), one obtains a Markovian system and in (57) all the coefficients depend on observable quantities.

5.2.2 GOP Dynamics Given its importance in our analysis, we now want to obtain also for the GOP a dynamics analogous to (57). For this purpose notice first that, with price dynamics (57) instead of (36), the dynamics (37) for the discounted portfolio values become (we use V¯ π,k to stress the information level/observation dimension k) d V¯ π,k (t) ˜ + d w(t)] ˜ = π (t)σ (t, C(t))[θ˜ (t, D(t))dt V¯ π,k (t)

(59)

where π(t) has now to be adapted to F k (t). This leads to the following adaptation of the definition of the set of admissible strategies, namely (see Definition 1) Definition 4 Given an initial wealthv, the set of admissible strategies under partial observation of level k is H k (v) := T >0 H k (v; T ) where

H k (v; T ) := π(·) ∈ F k (·) | P V v,π,k (t) ≥ 0, ∀ 0 ≤ t ≤ T = 1 . (60) By analogy with the case of complete observations (see (9) and notice that now we use discounted values), the growth rate of a portfolio π is here 1 ˜ − π (t)σ (t, C(t))σ (t, C(t))π(t) γπk (t) = π (t)σ (t, C(t))θ˜ (t, D(t)) 2 and it leads to the following GOP strategy −1 ˜ ˜ D(t)). θ(t, ρ k (t) = σ (t, C(t)) Substituting the expression for

ρ k (t)

into (59) we immediately obtain the

(61)

(62)

116


Proposition 17 The discounted value of the GOP (with unit initial wealth) satisfies d V¯ ρ,k (t) 2 ˜ ˜ dt + θ˜ (t, D(t))d w(t) ˜ = θ˜ (t, D(t)) V¯ ρ,k (t)

(63)

and the growth rate of the GOP is given by 1 2 ˜ γρk (t) = θ˜ (t, D(t)) . 2

(64)

5.2.3 GOP Strategy and Growth Rate Under Complete and Incomplete Observation Comparing the expressions for the GOP strategy and growth rate under complete observations (see (13) and (17)) with those under incomplete observations in (62) and (64) (notice that the growth rate under incomplete observation was derived for discounted values so that in (64) the additive term r(t) ∈ F k (t) is missing) we obtain Corollary 18 We have i)

ρ k (t) = E ρ(t) | F k (t) ,

ii) γρk (t) ≤ E γρ (t) | F k (t) . ˜ in (58), while for ii) we Proof i) is immediate considering the definition of θ˜ (t, D) use Jensen’s inequality and the fact that, under full observation, we have simply written θi (t) for what under incomplete observations is θ (t, A(t)). We thus obtain ˜ see (58)) (for the definition of θ˜i (t, D(t)) n n 1 2 1

2 ˜ = E θ˜i (t, D(t)) E E θi (t, A(t)) | F k (t) E γρk (t) = 2 2 i=1

i=1

n

1 2 E E θi (t, A(t)) | F k (t) ≤ 2 i=1 %% n 1 2 θi (t, A(t)) | F k (t) =E E 2 i=1

= E E γρ (t) | F k (t) = E γρ (t) .

5.2.4 Expected Utility Maximization Under Complete and Incomplete Observation Here we furthermore point out that, whenever one has to solve a problem for a partial observation model where the strategies have to be adapted to the filtration


117

representing the available information, then the original problem can equivalently be solved by solving it for the corresponding complete observation model. As an example, which will be relevant for Platen’s benchmark approach, we show that expected utility for the original incomplete observation problem is equivalent to the same problem for the corresponding complete observation model. The original problem can, for an arbitrary initial capital v > 0, be formulated as (see Definition 4 for the class of admissible strategies and (37) for the portfolio dynamics) ⎧ v,π ⎨ max E{U (V¯ (T ))} π∈H k (v;T ) ⎩ d V¯ v,π(t) = π (t)σ (t, C(t)) [θ (t, A(t))dt V¯ v,π(t)

+ dw(t)] .

For the corresponding complete observation model the problem becomes (see (59) for the portfolio dynamics) ⎧ v,π,k ⎪ (T ))} ⎨ max E{U (V¯ π∈H k (v;T ) v,π,k ⎪ ˜ ⎩ d V¯v,π,k (t) = π (t)σ (t, C(t))[θ˜ (t, D(t))dt V¯ (t)

+ d w(t)]. ˜

We show the following Lemma 19 max

π∈H k (v;T )

E{U (V¯ v,π (T ))} =

max

π∈H k (v;T )

E{U (V¯ v,π,k (T ))}.

Proof From (53) and (46) we obtain ˜ d W˜ (t) = (G(t, C(t)))−1 [F (t, D(t)) − F˜ (t, D(t))]dt + dW (t). Since V v,π (t) and V¯ v,π,k (t) are driven by w(t) and w(t) ˜ respectively, recalling the definitions of F (·), G(·) and F˜ (·) in (46) and (52) as well as the fact that the first n components of C(t) are (see (44)) the discounted prices S¯i (t), we have −1 ¯ ¯ diag(S(t))σ (t, C(t))θ (t, A(t)) d w(t) ˜ = (σ (t, C(t)))−1 diag(S(t)) ¯ − E diag(S(t))σ (t, C(t))θ (t, A(t)) | F k (t) dt + dw(t)

= θ (t, A(t)) − E θ (t, A(t)) | F k (t) dt + dw(t) ˜ = θ (t, A(t)) − θ˜ (t, D(t)) dt + dw(t). It follows that for any π ∈ H k (v; T )

E U V¯ v,π (T ) = E U exp v +

π (t)σ (t, C(t)) θ (t, A(t))dt + dw(t) 0 1 − σ (t, C(t))π(t)dt 2 T

118


= E U exp v +

˜ π (t)σ (t, C(t)) θ˜ (t, D(t))dt + d w(t) ˜ 0 1 − σ (t, C(t))π(t)dt 2

v,π,k (T ) . = E U V¯ T

5.3 Pricing According to the “Fernholz-Karatzas Approach” As we had seen in the complete observation case, in this approach the price corresponds to the minimal superreplicating initial capital and thus involves implicitly hedging strategies that are F k -adapted. In line with Sect. 5.2.4 we then use the same methodology as in Sect. 4.1 for the complete observation case, but applied here to the complete observation model that corresponds to the original incomplete observation model and was derived in the previous Sect. 5.2. When trying to carry over Theorem 3 to the present situation we face the problem that, although in addition to the primary assets also the empirical log-covariances are observable, the investment instruments are only the primary assets. We present now two possible variants of extensions of Theorem 3.

5.3.1 First Variant ¯ as In this variant we completely ignore the empirical covariances and consider S(t) ¯ the only observables, namely C(t) is the n-dimensional vector given by C(t) = S(t) and satisfying the subsystem of (46) consisting of the first n rows. The filtration F k remains as defined in (47) and the filter has the same form as in (48) and we also keep Assumption 12. Furthermore, analogously to (49) we now put ˜ D(t) = S¯1 (t), . . . , S¯n (t), ξ1 (t), . . . , ξq (t) . (65) ˜ as in (54). It is also easily seen that in the given situation F k (t) = F w˜ (t) with w(t) ˜ Replacing then θ (t) in (22) by θ˜ (t, D(t)) from (58), and using, instead of Z(t) in (18), the process t *2 1 t* k * * ˜ ˜ ˜ ˜ Z (t) := exp − ˜ − θ (s, D(s)) ds , 0 ≤ t < ∞ θ (s, D(s))d w(s) 2 0 0 (66) as “Radon-Nikodym process”, it can be easily verified that the following extension of Theorem 3 holds Theorem 20 Consider a given a maturity T and a claim Y k ∈ F k (T ) such that k (T ) k E{Y k ZB(T ) } ∈ (0, ∞) with Z (t) as in (66). For t ∈ [0, T ] and s ∈ [t, T ] denote by


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V v,π,k (s) the value in s ≥ t of a portfolio starting from V v,π,k (t) = v with π(·) ∈ F k (·). Let

Ht k (v; T ) := π(·) ∈ F k (·) | P V v,π,k (s) ≥ 0, ∀ t ≤ s ≤ T = 1; V v,π,k (t) = v ∈ F k (t) namely the set of admissible strategies starting from a capital v at time t and put

k (67) U Y (t) := ess inf v > 0 | ∃π ∈ Ht k (v; T ) s.t. V v,π,k (T ) ≥ Y k which represents the minimal hedging price at time t. Let, furthermore, k B(t) k k Z (T ) k Y (t) := k E Y | F (t) Z (t) B(T )

(68)

with Z k (t) as in (66) and with the expectation under the physical measure P . If F k (t) = F w˜ (t), where w(t) ˜ is the n-dimensional Wiener process according to Remark 16, then k

Y k (t) = U Y (t).

(69)

Proof The proof follows step by step that of Theorem 3 (with the appropriate adaptation of symbols) whereby M(s) in (23) is replaced by (recall that F k (t) = F w˜ (t)) s k Z k (t) k Z (T ) k ψ (u)d w(u) ˜ (70) M(s) := E Y | F (s) = Y k (t) + B(T ) B(t) t and π(s) turns out to be

ψ(s) ˜ + θ˜ (s, D(s)) π(s) = σ −1 (s, C(s)) M(s)

for s ∈ [t, T ] with t ∈ [0, T ].

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5.3.2 Second Variant This is a more theoretical variant, where one imagines the possibility of investing also in the log-covariances (in general in all quantities that are supposed to be ob˜ servable). In this case C(t) and D(t) remain as in Sect. 5.2 where C(t) satisfies (46) ¯ with W (t) as in (45) (recall also that this implies that the diag (S(t)) σ (t, C(t)) of the first variant now becomes G(t, C(t))). Furthermore (see Remark 15), this time ˜ F k (t) = F W (t) with W˜ (t) as in (53). The extension of Theorem 3 for the present variant now reads exactly as Theorem 20. In the proof of the Theorem for this second variant the changes with respect to the first variant concern, besides C(t), the ˜ ˜ D(t)) process θ(t, that now has to be of dimension k = 2n. The other changes concern Z k (t) in (66) that now becomes t *2 1 t* * ds , 0 ≤ t < ∞ *θ˜ (s, D(s)) ˜ ˜ θ˜ (s, D(s))d W˜ (s) − Z k (t) := exp − 2 0 0 (72)

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with W˜ (t) as in (53). Furthermore, M(t) here becomes s Z k (T ) Z k (t) | F k (s) = Y k (t) + M(s) := E Y k ψ (u)d W˜ (u) B(T ) B(t) t with ψ(t) a 2n-dimensional process and the hedging strategy is ψ(t) ˜ + θ˜ (t, D(t)) . π(t) := G−1 (t, C(t)) M(t)

(73)

(74)

5.4 Pricing According Platen’s “Benchmark Approach” As we had seen in the complete observation case, Platen’s approach is of the type of utility indifference pricing. In line with Sect. 5.2.4 we then use the same methodology as in Sect. 4.2 for the complete observation case, but applied here to the complete observation model that corresponds to the original incomplete observation model and was derived in Sect. 5.2. Contrary to what happened for the FernholzKaratzas approach in Sect. 5.3, where we had to consider two somewhat restricted variants, here it can be seen that we can follow the exact same steps as in the proof of Theorem 8 for the complete observation case (with the appropriate adaptation of symbols). We thus conclude that the following formula holds for the price P k (t) under incomplete observation with information level/observation dimension k Yk k ρ,k k P (t) = V (t)E (75) | F (t) V ρ,k (T ) where the discounted version of V ρ,k (t) satisfies (63).

5.5 Comments on the Equivalence of the Two Approaches in the Case of Incomplete Observations In Sect. 4.3 we have shown that, in case of complete observations, the FernholzKaratzas (F.-K.) and Platen’s benchmark (PB) approach lead to the same derivative prices. In the case of incomplete observations the formulas that we have derived in Sects. 5.3 and 5.4 correspond to those in Sects. 4.1 and 4.2 respectively and so the equivalence should also hold for incomplete observations. However, while PB can be applied also if not all observables can be used as investment instruments (in the case of this paper the empirical covariances), FK had to be restricted to situations where all observables are also investment instruments. This corresponds to intuition if one considers that FK relies on completing the market, while PB is of the utility indifference pricing type that is typically designed for incomplete markets. This difference did not come up in the complete observation case because there all investment instruments are automatically observable.


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Acknowledgements Part of the contribution by the second author was obtained while he was visiting professor 2009 for the chair Quantitative Finance and Insurance at the LMU University in Munich funded by LMU Excellent. Hospitality and financial support are gratefully acknowledged as are the useful suggestions by the participants to a series of seminars on the topic of the paper.

References 1. Fernholz, E.R.: Stochastic Portfolio Theory. Springer, New York (2002) 2. Fernholz, E.R., Karatzas, I.: Stochastic portfolio theory: an overview. In: Bensoussan, A., Zhang, Q. (eds.) Mathematical Modeling and Numerical Methods in Finance. Handbook of Numerical Analysis, vol. XV, pp. 89–168. North-Holland, Amsterdam (2008) 3. Galesso, G.: Arbitraggio e diversificazione in informazione completa e parziale. Thesis, Univesity of Padova (2008) 4. Liptser, R., Shiryaev, A.: Statistics of Random Processes: I. General Theory. Springer, Berlin (1977) 5. Platen, E., Heath, D.: A Benchmark Approach to Quantitative Finance. Springer Finance, Springer, Berlin (2006) 6. Platen, E., Runggaldier, W.J.: A benchmark approach to filtering in finance. Asia-Pac. Financ. Markets 11, 79–105 (2005) 7. Platen, E., Runggaldier, W.J.: A benchmark approach to portfolio optimization under partial information. Asia-Pac. Financ. Markets 14, 25–43 (2007) 8. Schachermayer, W.: Utility maximization in incomplete markets. In: Frittelli, M., Runggaldier, W. (eds.) Stochastic Methods in Finance. Lecture Notes in Mathematics, vol. 1856, pp. 255–293. Springer, Berlin (2004)

Existence and Non-uniqueness of Solutions for BSDE Xiaobo Bao, Freddy Delbaen, and Ying Hu

Abstract We study BSDE where the driver is pathwise quadratically bounded. The associated utility function is always a solution but even in the class of Markovian solutions uniqueness is not guaranteed. we relate the problem to problems for quasilinear parabolic PDE.

1 Notation We will use standard notation. Time will be continuous and the time interval [0, T ] is bounded. The probability space (Ω, FT , P) is big enough to carry a d-dimensional Brownian Motion W . The filtration F = (Ft )t∈[0,T ] is generated by W and F0 contains all the negligible sets of FT . It is well known that it satisfies the usual assumptions, i.e. F is also right continuous. We will study Backward Stochastic Differential Equations (BSDE) of the type dYt = g(t, Zt ) dt − Zt dWt , where the terminal condition YT = ξ ∈ L∞ is bounded and where the solution Y is supposed to be bounded. We know that for some drivers g, see below for precise conditions, there is a relation with utility theory. In [3] the general form of a Fatou utility function u0 such that for all ξ ∈ L∞ , u0 (ξ ) ≤ EP [ξ ], was found. It is given by the expression: T u0 (ξ ) = inf EQ ξ + fu (qu ) du . 0

The function f has the following properties F. Delbaen () · X. Bao Department of Mathematics, ETH Zurich, Zurich, Switzerland e-mail: [email protected] Y. Hu Département de Mathématiques, Université de Rennes-1, Rennes, France C. Chiarella, A. Novikov (eds.), Contemporary Quantitative Finance, DOI 10.1007/978-3-642-03479-4_7, © Springer-Verlag Berlin Heidelberg 2010

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f : [0, T ] × Ω × Rd → R+ , for each q ∈ Rd , the partial function on [0, T ] × Ω is predictable, for each (u, ω) the partial function is lsc and convex on Rd , the function f is measurable for B × P, where B is the Borel σ -algebra on Rd and P is the predictable σ -algebra on [0, T ] × Ω, 5. f (u, ω, 0) = 0 for each (u, ω). 1. 2. 3. 4.

The infimum is taken over all probability measures Q that – on the sigma-algebra ) is then given by a stochastic exFT – are equivalent to P. The density process ( dQ dP2 t t 1 t ponential E (q · W )t = exp( 0 qu dWu − 2 0 |qu | du), where q is a d-dimensional T predictable process that – because Q ∼ P – satisfies 0 |qu |2 du < ∞ a.s. Each time we use a measure Q, the process q will have this meaning. One can show that the T penalty function, c0 (Q) = EQ [ 0 fu (qu ) du], can be extended to a function defined for all Q P and that it has the same expression, provided the integrals are taken with some liberal interpretation. For details we refer to [3]. There is only one time consistent extension of the utility function u0 to a utility process. It is given by T ut (ξ ) = ess.infQ∼P E ξ + fu (qu ) du | Ft . t

It is shown, see [3] and [2], that there is a càdlàg version for the process u. Of course this is the version we will use. The Legendre transform of f (t, ω, .) is denoted by g(t, ω, z) and it has similar properties as f . We make the standing assumption that g takes finite values. A statement equivalent to: for each (t, ω): lim|q|→+∞ f (t,ω,q) = ∞. This means that f has |q| sufficient growth. It rules out the case that f is e.g. 0 on subspaces. We leave it as an exercise for the reader to show that also g is predictable in (t, ω). The following theorem gives an inequality between the solutions of BSDE and the utility process. Theorem 1 Suppose that the continuous process Y is bounded and that it satisfies dYt = gt (Zt ) dt − Zt dWt . YT = ξ We then have Y ≤ u(ξ ). Proof Let Q ∼ P be a measure such that c0 (Q) < ∞, then T EQ ξ + fu (qu ) du | Ft t T = Yt + EQ (gu (Zu ) + fu (qu ) − qu Zu ) du | Ft t

≥ Yt . Taking the infimum over all such measures Q gives ut (ξ ) ≥ Yt .

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The key to applications is the following “verification” theorem. Theorem 2 Suppose ξ ∈ L∞ and suppose that there exists an equivalent measure Q ∼ P such that T u0 (ξ ) = EQ ξ + fu (qu ) du . 0

Then there exists a process Z such that for all t ≤ T : T T gu (Zu ) du − Zu dWu . ξ = ut (ξ ) + t

t

The process defined by Y0 = u0 (ξ ) and dYt = gt (Zt ) dt − Zt dWt is bounded and YT = ξ . The backward stochastic differential equation dYt = gt (Zt ) dt − Zt dWt YT = ξ has a bounded solution. T Proof Let Q be such that u0 (ξ ) = EQ [ξ + 0 fu (qu ) du]. The density process of Q is given by the stochastic exponential E (q · W ). We also have that T ut (ξ ) = EQ ξ + fu (qu ) du | Ft . t

t

It follows that ut (ξ ) + 0 fu (qu ) du is a Q-martingale. But for other measure Q , in t particular for P, the process ut (ξ ) + 0 fu (qu ) du is a Q -submartingale. The DoobMeyer decomposition – under P – of the P-submartingale, u(ξ ), can be written as dut (ξ ) = dAt − Zt dWt , where the process Z · W is a BMO-martingale, see below for a proof of this well known fact. The decomposition under Q therefore becomes dut (ξ ) = dAt − qt Zt dt − Zt dWtQ . The martingale property shows that dAt = (qt Zt − ft (qt ))dt. But Q is a minimising measure and hence for all other density processes E (k · W ) we must have dAt ≥ (kt Zt − ft (kt ))dt, which shows that dAt = gt (Zt ) dt. Combining these results yields dut (ξ ) = gt (Zt )dt − Zt dWt as required. The other statements are trivial consequences. Remark 1 We do not claim uniqueness of the solution. In fact we will see later that uniqueness is not always valid. By Ekeland’s variational principle, see [5] for the appropriate version of the BishopPhelps theorem, the set T ξ | there is Q P such that u0 (ξ ) = EQ ξ + fu (qu ) du 0

L∞ .

But there is no guarantee that a minimising measure is equivis norm dense in alent to P. This is the topic of Sect. 3.

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2 A Convergence Result We now present some results on the decomposition of semimartingales. Let us introduce the following space ⎫ ⎧ X is a continuous semi-martingale, X0 = 0 ⎪ ⎪ ⎪ ⎪ ⎪ X = A + M, A0 = 0, is the Doob-Meyer decomposition ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎨ A is of finite total variation BMO . = X S M is a continuous BMO-martingale ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ∞ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭ ⎩ there is C such that for all t : E |dAu | | Ft ≤ C < ∞ ⎪ t

The space S can be given a norm

X = sup E t

t

∞

|dAu | | Ft

∞

+ M BMO2 .

The space is a Banach space and using the martingale convergence theorem, one can show that both A and M converge when t → ∞. An equivalent norm is sup E[ |(θ · X)∞ − (θ · X)t | | Ft ] ∞ , where the sup is taken over all t and all predictable θ with |θ | ≤ 1. This is not trivial but can be proved as follows. For each ε > 0 there is a predictable process θ, |θ | ≤ 1 such that |θ · A| ≤ ε. This allows to give an estimate for the M BMO1 norm. Once you know that M is BMO, one can choose θu such that θ dAu = |dAu |. Then you ∞ get the bound for E[ t |dAu | | Ft ]. From here the rest is trivial. The mapping SBMO → BMO; X → M, is of course continuous. For applications in utility theory we need an estimate based on the supremum of the process. But even for deterministic processes there is a big difference between the quantity X and expressions such as supt |Xt |. Nevertheless the martingale part can be estimated using the supremum of the process. Lemma 1 Let X be a continuous bounded submartingale bounded by a constant c. Suppose that X has the continuous Doob-Meyer decomposition X = A + M, then the martingale part M is in BMO, more precisely M BMO2 ≤ 2c and X SBMO ≤ 4c. Consequently A∞ has exponential moments of some order. ∞ Proof The process A satisfies E[ t dAu | Ft ] = E[X∞ − Xt | Ft ] ≤ 2c. This already shows that X ∈ SBMO . However this only yields a bound for the BMO1 norm and the bound is not the best. We prefer to give a direct proof. First observe that the process Y = (c − X)2 is given by the differential equation dYt = 2(c − Xt )dAt + dM, M t + 2(c − Xt ) dMt .


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Since the coefficient c − Xt is nonnegative, the process Y is also a bounded submartingale and taking conditional expectations gives E t

∞

dM, M u | Ft ≤ E[Y∞ − Yt | Ft ] ≤ E[Y∞ | Ft ].

Consequently

E

∞

dM, M u | Ft ≤ 4c2 .

t

Hence M BMO ≤ 2c. Because M is BMO it has – by the John-Nirenberg inequality, see [4] – some exponential moments. Because X is bounded also A∞ must have exponential moments. Lemma 2 For X ∈ SBMO and X bounded, we have

M 2BMO2 ≤ 8 sup |Xt | 2∞ + 8 sup |Xt | ∞ X . t

t

Proof Let c = supt |Xt | ∞ . The following inequalities are now straightforward. If needed one can use a localisation argument by stopping the processes when they reach a level. E[(M∞ − Mt )2 | Ft ] ≤ 2E[(X∞ − Xt )2 | Ft ] + 2E[(A∞ − At )2 | Ft ] ∞ (Au − At )dAu | Ft ≤ 8c2 + 4E t ∞ 2 ≤ 8c + 4E (Au − At )dXu | Ft t ∞ 2 ≤ 8c + 4E (X∞ − Xu )dAu | Ft t ∞ ≤ 8c2 + 8cE |dAu | | Ft . t

This shows the bound on M BMO2 .

Corollary 1 If X n is a sequence in SBMO , supn X n < ∞, if supt |Xtn − Xt | ∞ → 0, then X ∈ SBMO and the martingale parts of the Doob-Meyer decompositions satisfy M n → M in BMO. Proof Only the statement that X ∈ SBMO needs to be shown. By the inequality we get that limn,m→∞ (M n − M m ) → 0 in BMO. So the Cauchy sequence converges to some M ∈ BMO. The finite variation part then also converges to a process ∞ A in the sense that supt |Ant − At | tends to zero at least in probability. That E[ t |dAu | | Ft ] ≤ supn X n is straightforward. So X ∈ SBMO , X ≤ supn X n .

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Remark 2 Of course we did not make a statement on norm convergence in the space SBMO . As already observed above, even for deterministic bounded variation processes, the convergence in sup-norm is not the same as the convergence in variation norm. Corollary 2 If (X n )n≥1 is a uniformly bounded sequence of submartingales |Xtn | ≤ c, if supt |Xt − Xtn | ∞ tends to 0, then the Doob-Meyer decompositions X n = An + M n , X = A + M satisfy M n tends to M in BMO. Proof The previous corollary shows that X n ≤ C (where C only depends on c). The convergence of the martingale parts now follows. Remark 3 If in the corollary we replace the condition supt |Xt − Xtn | ∞ tends to 0 by the weaker condition supt |Xt − Xtn | → 0 a.s., then the conclusion is wrong, even for sequences of uniformly bounded martingales. Indeed there is a sequence of uniformly bounded martingales M n such that supt |Mtn − Mt | tends to 0 a.s., but the convergence in BMO is false. This has to do with the fact that the map H 1 → L1 is not weakly compact. We do not give details.

3 Pathwise Subquadratic Drivers Theorem 3 Suppose that for every ω ∈ Ω there is a constant K < ∞ depending on ω such that for all t: gt (z) ≤ K(1 + |z|2 ). Suppose that Q is a minimising measure for ξ , then necessarily Q ∼ P. We need the following lemma: Lemma 3 If φ: Rd → R+ is a convex function such that φ(z) ≤ K(1 + |z|2 ) for all z ∈ Rd . Then every q ∈ ∂z φ (q an element of the subgradient of φ in the point z) satisfies |q| ≤ 5K(1 + |z|). Proof Take z ∈ Rd and q ∈ ∂z φ. Because of convexity we have for all w ∈ Rd : φ(z + w) − φ(z) ≥ q · w. If |z| ≥ 1 we apply this inequality for all w with |w| = |z| and we get K(1 + 4|z|2 ) ≥ |q| |z|. This implies that |q| ≤ 4K(1 + |z|) for |z| ≥ 1. For |z| ≤ 1 we take the inequality for all |w| = 1 and we get 5K ≥ |q|. The two cases can be written as |q| ≤ 5K(1 + |z|). Proof We will need the Lebesgue measure m on [0, T ]. Let dut (ξ ) = dAt − Zt dWt be the Doob-Meyer decomposition of the process u(ξ ). Let the density process D of Q be given by the stochastic exponential E (q · W ). Let τ = inf{t | Dt = 0}. Since 0 < τ is predictable we have that there is a sequence τn 0 a.s., meaning Q ∼ P. Theorem 4 Suppose that for every ω ∈ Ω there is a constant K depending on ω such that for all t: gt (z) ≤ K(1 + |z|2 ). For every ξ ∈ L∞ the process u(ξ ) is a bounded solution of the BSDE: dYt = gt (Zt ) dt − Zt dWt . YT = ξ Proof By the Bishop-Phelps theorem there is a sequence ξn → ξ (in L∞ norm) such that for ξn there is a minimising measure Qn . By the preceding theorem this measure is equivalent to P. By the “verification” theorem we can write dut (ξn ) = gt (Ztn ) dt − Ztn dWt . Since supt |ut (ξn ) − ut (ξ )| ≤ ξn − ξ we can apply the results of the previous section and hence we get that Z n · W → Z · W in BMO. T This implies 0 |Ztn − Zt |2 dt → 0 in probability. The hypothesis on g then ims s plies that in probability: 0 gt (Ztn ) dt → 0 gt (Zt ) dt for every s ≤ T . We get s s us (ξ ) = u0 (ξ ) + 0 gt (Zt ) dt − 0 Zt dWt .

4 The Relation with Minimal Elements For ξ ∈ L∞ we know that the process u(ξ ) is a P-submartingale and hence has a Doob-Meyer decomposition dut (ξ ) = dAt − Zt dWt . Because for Q ∼ P with t c0 (Q) < ∞, the process ut (ξ ) + 0 fu (qu ) du is a Q-submartingale we must have that dAt ≥ gt (Zt ) dt. So we can write dut (ξ ) = gt (Zt ) dt + dCt − Zt dWt , where C is a nondecreasing process, with C0 = 0. The discontinuity points of C must be the same as the discontinuity points of u(ξ ). So we get that the jumps of C must be bounded by the jumps of u(ξ ) and hence smaller than 2 ξ . It follows that the process C is locally bounded. We already saw that the existence of a minimising measure Q ∼ P implies that CT = 0. There is also a relation with minimal elements, see also [1]. These are defined as follows Definition 1 An element ξ ∈ L∞ is called minimal if for each η ∈ L∞ + , P[η > 0] > 0 we have u0 (ξ − η) < u0 (ξ ). Proposition 1 If ξ is minimal then for each stopping time σ , the element uσ (ξ ) is minimal. Proof Take η ≤ uσ (ξ ) such that u0 (η) = u0 (uσ (ξ )) and P[η < uσ (ξ )] > 0. Obviously we have uσ (η) ≤ uσ (ξ ). We first show that uσ (η) < uσ (ξ ) on a set of positive

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measure. Indeed if, uσ (η) = uσ (ξ ), then uσ (ξ ) ≥ EP [η | Fσ ] since η ≤ uσ (ξ ) ≥ uσ (η) = uσ (ξ ), hence uσ (ξ ) = EP [η | Fσ ]. Integrating with respect to P gives uσ (ξ ) dP = η dP, a contradiction to P[η < uσ (ξ )] > 0. This shows P[uσ (η) < uσ (ξ )] > 0. We then get u0 (ξ − (uσ (ξ ) − uσ (η))) = u0 (uσ (ξ − (uσ (ξ ) − uσ (η)))) = u0 (uσ (η) = u0 (η) = u0 (uσ (ξ )) = u0 (ξ ),

showing that ξ was not minimal, a contradiction.

Theorem 5 If ξ is minimal, then CT = 0 and hence the process u(ξ ) is a bounded solution of the BSDE: dYt = gt (Zt ) dt − Zt dWt . YT = ξ Proof If CT = 0 there is a stopping time σ , such that Cσ is bounded and P[Cσ > 0] > 0. Indeed take ε > 0 such that P[CT > ε] > 0. Take now σ = inf{t | Ct ≥ ε}. Since the jumps of C are bounded we have that Cσ is bounded. We can now write σ σ gu (Zu ) du − Zu dWu . uσ (ξ ) − Cσ = u0 (ξ ) + 0

0

This shows that we have a bounded solution of the BSDE with endpoint uσ (ξ ) − Cσ and starting point u0 (ξ ). The proposition then gives u0 (uσ (ξ ) − Cσ ) ≥ u0 (ξ ). But we certainly have u0 (uσ (ξ ) − Cσ ) ≤ u0 (uσ (ξ )) = u0 (ξ ). This shows u0 (uσ (ξ ) − Cσ ) = u0 (ξ ) and hence uσ (ξ ) cannot be minimal, a contradiction to the previous proposition. We conclude that CT = 0. Remark 4 The converse is not true. We can show that there is a utility function u and a random variable ξ such that u(ξ ) satisfies the associated BSDE but ξ is not minimal, see [1]. This shows that the characterisation of those ξ for which the BSDE has a solution is not an easy problem. But we can show the following: Theorem 6 Suppose that for every ω ∈ Ω there is a constant K < ∞ depending on ω such that for all t: gt (z) ≤ K(1 + |z|2 ). Every ξ ∈ L∞ is then minimal. Proof The proof uses that the process u(ξ ) is a solution of the BSDE. Suppose that u0 (ξ ) = 0 and dut (ξ ) = gt (Zt ) dt − Zt dWt . For each ω ∈ Ω there is a constant K(ω) such that gt (z) ≤ K(1 + |z|2 ). We can of course suppose that K is measurable for FT . To find a minimising measure we can try a selection q of ∂Z g but of


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course there is no guarantee that the stochastic exponential E (q · W ) is uniformly integrable. Nevertheless this is the idea behind the proof. To show that ξ is minimal we take A ∈ FT , δ > 0 and we must show that u0 (ξ − δ1A ) < 0. Take N big enough so that P[A ∩ {K ≤ N }] > 0. Define the stopping time σ as σ = inf{t | |qt | > 5N (1 + |Zt |} ∧ T }. By the lemma above {σ < T } ⊂ {K > N } and therefore P[A ∩ {σ = T }] > 0. We now show that the stochastic exponential σ σ E (q · W ) stopped at σ is uniformly integrable. Since uσ (ξ ) = 0 gt (Zt ) dt − 0 Zt dWt , we have Z · W is in BMO. But |q|1J0,σ J ≤ 5N (1 + |Z|) and hence q · W is also in BMO. Therefore E (q1J0,σ J · W ) = E (q · W )σ is uniformly integrable, see σe.g. [4]. The measure dQ = E (q · W )σ dP satisfies 0 = u0 (uσ (ξ )) = EQ [uσ (ξ ) + 0 ft (qt ) dt]. We also have that Q ∼ P. The following inequalities are now obvious u0 (ξ − δ1A ) = u0 (uσ (ξ − δ1A )) ≤ u0 uσ (ξ − δ1A∩{σ =T } ) ≤ u0 uσ (ξ ) − δ1A∩{σ =T } σ ft (qt ) dt − δQ[A ∩ {σ = T }] ≤ EQ uσ (ξ ) + 0

< 0.

5 An Example Here we take a coherent utility given by a non-weakly compact set S , i.e. u0 (ξ ) = inf EQ . Q∈S

The set will be taken in such a way that all its elements are equivalent to P. We will make use of the BES 3 process which provides a good example of a strict local martingale. The notation is standard. We take d = 1 and dRt = Rdtt + dWt , Lt = 1/Rt , R0 = L0 = 1, dLt = −L2t dWt . The process L is a strict local martingale since EP [Lt ] < 1 for all t > 0. Then we take dQ L2 1 S = Q| = E (q · W ), |q| ≤ = . dP 1 + L R(R + 1) −L2

This set is not weakly compact. This can be seen as follows. If we take q = 1+Lt t , then the solution of dVt = qt Vt dWt , V0 = 1 is precisely V = 1+L 2 , which is a strict local martingale. The stopped processes V σn where σn = inf{t | Vt ≥ n} ∧ T , are bounded and define elements of S . Since VTσn converges to VT and since

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E[VT ] < 1, the set S is not uniformly integrable. The function f is given by ft (q) = 0 if |q| ≤

L2t 1+Lt

and equals +∞ elsewhere. The conjugate is then gt (z) =

L2t 1 |z|, |z| = 1 + Lt Rt (1 + Rt )

which certainly satisfies the hypothesis of the theorems in Sects. 2 and 3. So we have that for ξ ∈ L∞ , ut (ξ ) is a solution of the BSDE dYt = gt (Zt ) dt − Zt dWt ,

YT = ξ,

Y bounded.

We claim that even for functions of the form ξ = φ(RT ), there is no uniqueness, even in the class of processes which are functions of t and Rt . An easy appli1 t cation of Itô’s formula gives that φ(Rt ) = 1+L = RRt +1 is a bounded solution of t 1 the BSDE with terminal condition ξ = 1+LT . We will show that for T big enough (and maybe with some effort for every T > 0), u0 (ξ ) > 1/2. In fact we will show 1 that limT →∞ u0 ( 1+L ) = 1, something to be expected since LT → 0 as T → +∞. T However since S is not weakly compact such interchanges of limits and integrals is more delicate. The Markov property of R implies that also ut (ξ ) is a function that only depends on t and Rt . We will see what this means for the related PDE. 1 Theorem 7 limT →∞ u0 ( 1+L ) = 1. T

Proof The proof is surprisingly difficult and maybe there is an easier way. We divide the proof in several steps. Lemma 4 supQ∈S EQ [RT ] ≤

√ 1 + 5T .

Proof We calculate EQ [RT2 ]. Under Q the BESQ3 -process follows the equation d(R 2 )t = 2Rt dRt + dt = 3dt + 2Rt qt dt + 2Rt dWtQ . Since |qt | ≤

1 Rt (Rt +1) ,

we get that

2 dt ≤ 1 + 5T . 0 1 + Rt 1 1 √ EQ 1+R ≤T 1 + 5T − 1 → 0 as T → ∞. T

EQ [RT2 ] ≤ 1 + 3T + EQ Lemma 5 supQ∈S

T

1 is a Q-supermartingale as Itô’s Proof This is tricky. Under Q the process 1+R t lemma shows. Also 1 1 1 dRt = + qt dt + dWtQ with + qt ≥ . Rt Rt 1 + Rt


133

So we get EQ [RT ] ≥ 1 + EQ

0

T

1 1 dt ≥ 1 + T EQ . 1 + Rt 1 + RT

Together with the previous lemma, we get the desired inequality.

We can now complete the proof of the theorem. RT 1 = 1 − sup EQ inf EQ Q∈S 1 + RT 1 + RT Q∈S 1 √ 1 + 5T − 1 ≥1− T → 1 as T → ∞.

If we summarise what we have calculated so far, we get that for T big enough: u0 (ξ ) > 1/2 and hence we have two Markovian solutions of the equation dYt = gt (Zt ) dt − Zt dWt ,

YT = ξ,

Y bounded.

Rt RT 1 One solution is the process 1+L = 1+R , the other solution is u(t, Rt ) = ut ( 1+R ). t t T If we write the PDE related to this problem we get

1 1 1 ∂t u + ∂xx u + ∂x u = |∂x u|, 2 x x(x + 1) leading to

1 1 1 − sign(∂x u) ∂x u = 0. ∂t u + ∂xx u + 2 x x(x + 1)

The domain where we look for the solution is [0, T ] × (0, ∞) and the boundary x condition is u(T , x) = 1+x . Of course we did not discuss the regularity for the utility function, but PDE theory either shows that it is regular or we just see it as a viscosity RT solution. We do not go into details. For a terminal value of the form 1+R we can T get rid of the sign-function. Indeed the non-confluence result for SDE’s shows that the process R is increasing in its starting value. As a result we get that conditional x on Rt = x, the endpoint RT is increasing in x. The function 1+x itself is increasing and hence we get by monotonicity of u that ∂x u ≥ 0. The PDE then simplifies to 1 1 ∂x u = 0 on [0, T ] × (0, ∞). ∂t u + ∂xx u + 2 x+1 This seems a nice linear equation and we found two (hence infinitely many) bounded solutions of it. The reason can be explained using stochastic theory. The above equation is the equation that gives martingales for a diffusion of the form dVt =

1 dt + dWt , V0 = x > 0. Vt + 1

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The solution is explicitly known as Vt = Rt − 1, where R is a BES3 -process starting at x + 1. The process V can reach the value 0 and hence the stochastic approach to solve the boundary value problem requires that either we give conditions for the final value on (−1, +∞) or we give a condition when crossing the level 0, i.e. we also need a boundary value on the set (0, T ] × {0}. In any case the linear PDE cannot have a unique solution. x , x ≥ 0 for −1 < x < 0 allows to produce a Remark 5 Continuing the function x+1 very big set of solutions. We do not pursue this rather delicate issues.

Acknowledgements This research was sponsored by a grant of Credit Suisse. The text only reflects the opinion of the authors. We also thank Mete Soner for discussions on PDE.

References 1. Bao, X.: Backward stochastic differential equations with super-quadratic growth. Ph.D. thesis, ETH-Zurich (2009) 2. Bion-Nadal, J.: Time consistent dynamic risk processes. Stoch. Process. Appl. 119(2), 633–654 (2009) 3. Delbaen, F., Peng, S., Rosazza-Gianin, E.: Representation of the penalty term of dynamic concave utilities. Finance Stoch., accepted (2009) 4. Kazamaki, N.: Continuous Exponential Martingales and BMO. Lecture Notes in Mathematics, vol. 1579. Springer, Berlin (1994) 5. Phelps, R.R.: Convex Functions, Monotone Operators and Differentiability. Lecture Notes in Mathematics, vol. 1364, 2nd edn. Springer, Berlin (1993)

Comparison Theorems for Finite State Backward Stochastic Differential Equations Samuel N. Cohen and Robert J. Elliott

Abstract Most previous contributions on BSDEs, and the related theories of non linear expectation and dynamic risk measures, have been in the framework of continuous time diffusions or jump diffusions. Using solutions of BSDEs on spaces related to finite state, continuous time Markov Chains, we discuss a theory of nonlinear expectations in the spirit of Peng (math/0501415 (2005)). We prove basic properties of these expectations, and show their applications to dynamic risk measures on such spaces. In particular, we prove comparison theorems for scalar and vector valued solutions to BSDEs, and discuss arbitrage and risk measures in the scalar case.

1 Introduction How to model and modify the future is a central human activity. In particular, a re-occurring concern is how to quantify and mitigate risk. Introducing negatives of quantities involved, this is related to investigating the maximisation of some expected future reward, taking into account the randomness involved. Risk measures such as VaR (Value at Risk), and CVaR (Conditional Value at Risk), have well known deficiencies: in the case of VaR they can discourage diversification, and neither VaR nor CVaR is guaranteed to make consistent decisions through time. A topic of current interest is how to define practical measures of risk which are time consistent. Such measures of risk are of great importance, as they allow us to model and understand risk-averse behaviour, while avoiding paradoxes S.N. Cohen · R.J. Elliott School of Mathematical Sciences, University of Adelaide, Adelaide 5005, Australia S.N. Cohen e-mail: [email protected] R.J. Elliott () Haskayne School of Business, University of Calgary, Calgary T2N 1N4, Canada e-mail: [email protected] C. Chiarella, A. Novikov (eds.), Contemporary Quantitative Finance, DOI 10.1007/978-3-642-03479-4_8, © Springer-Verlag Berlin Heidelberg 2010

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S.N. Cohen and R.J. Elliott

and inconsistencies arising from decisions being made on different dates, when different information is available. We now know that such measures can be defined as solutions of Backward Stochastic Differential Equations (see [8, 18]). In this paper and related recent work we consider backward equations on a finite state space, where the noise derives from a Markov chain. Related non linear expectations and dynamic risk measures can be defined once a comparison theorem is established. The theory of Backward Stochastic Differential Equations (BSDEs) is applicable to many problems in Mathematical finance and elsewhere. As discussed in [11], BSDEs encompass the classical pricing theory of Black, Scholes, Merton and others, as well as many examples of pricing in incomplete markets. In [8, 18, 22] and others, BSDEs have been used to generate ‘nonlinear expectations’, that is, operators which behave in many ways like the classical expectations operator, but are not necessarily linear. Similarly, [10] developed a theory of recursive utilities in continuous time, while [3, 9, 23] and others have explored the use of BSDEs in the theory of dynamic risk measures, in the sense of [1, 15]. A key result in these applications is the ‘comparison theorem’, first given in [21], which establishes certain monotonicity properties of the operators considered. The above contributions deal with the classical BSDE driven by a standard Wiener process. Other work has considered allowing jumps, primarily in the context of a Lévy process, for example [2, 4, 12, 20, 24]. A significant issue here is that the original comparison theorem no longer applies – see [2] for a counterexample – and so further restrictions must be placed on the terms of the equations to ensure the desired properties hold. These conditions do not easily extend to other settings, and apply only to the case where the equations considered are scalar. In this paper a situation is considered where randomness is generated by a continuous time, finite state Markov chain. A corresponding discrete time theory is covered in our paper [7]. Both scalar and vector comparison theorems are stated in this framework. Following [22] we then develop a theory of nonlinear expectations. Full proofs are given in the paper [6].

2 A Mathematical Setting Consider a continuous time, finite state Markov chain X = {Xt , t ∈ [0, T ]}. Without loss of generality, we identify the states of this process with the standard unit vectors ei in RN , where N is the number of states of the chain. Consider stochastic processes defined on the filtered probability space (Ω, F , {Ft }, P), where {Ft } is the completed natural filtration generated by the σ -fields Ft = σ ({Xu , u ≤ t} ∪ {F ∈ FT : P(F ) = 0}), and F = FT . As X is a rightcontinuous jump process with distinct jumps, this filtration is right-continuous. If At denotes the rate matrix for X at time t, then this chain has a semimartingale representation Xt = X0 + Au Xu− du + Mt (1) ]0,t]

Comparisons for Finite State BSDEs

137

where Mt is a martingale. (See Appendix B of [14].) As in [5], we know that the predictable quadratic covariation matrix of this martingale, M, Mt , has the representation (diag(Au Xu− ) − Au diag(Xu− ) − diag(Xu− )A∗u )du. (2) M, Mt = ]0,t]

As in our earlier paper, [5], consider pairs (Y, Z), Zt ∈ RK×N adapted and left continuous, Yt ∈ RK adapted and càdlàg, which are solutions to equations of the form Yt − F (ω, u, Yu− , Zu )du + Zu dMu = Q. (3) ]t,T ]

]t,T ]

Here Q is an FT measurable, RK valued, P-square integrable random variable and F is a map Ω × [0, T ] × RK × RK×N → RK which is progressively measurable. Let ψt be the nonnegative definite matrix ψt := diag(At Xt− ) − At diag(Xt− ) − diag(Xt− )A∗t

(4)

Z 2Xt− := Tr(Zψt Z ∗ ).

(5)

and

Then · Xt− defines a (stochastic) seminorm, with the property that Tr(Zt dM, Mt Zt∗ ) = Zt 2Xt− dt.

(6)

We have shown the following result in [5]. Theorem 1 For Q ∈ L2 (FT ), if F is Lipschitz continuous, in the sense that there exists c ≥ 0 such that, for any Z 1 , Z 2 , Y 1 , Y 2 square integrable and of appropriate dimension, 1 2 1 2 , Zt1 ) − F (u, Yt− , Zt2 ) ≤ c( Zt1 − Zt2 Xt− + Yt− − Yt− ) F (t, Yu−

dt × P-a.s., then there exists a solution (Y, Z) to (3), such that 2 E Yt du < +∞ E

]0,T ]

]0,T ]

Zt 2Xt− du < +∞,

and this solution is the unique such solution, up to indistinguishability for Y and equality dM, Mt × P-a.s. for Z. We shall describe properties and applications of these solutions. Note that, where appropriate, we shall denote by ≤, ≥, etc. . . an inequality holding simultaneously on all components of a vector quantity.

138


3 Some Lemmas We restrict ourselves to deterministic T ; however, it is clear that, as observed in [6], given appropriate modifications, the results stated could easily be modified to remain valid when T is an essentially bounded stopping time. We now state, without proof, some Lemmas whose proofs are given in [6]. We shall henceforth assume that F is P-a.s. left continuous in t, is Lipschitz continuous as in Theorem 1 and satisfies F (ω, t, Yt− , Zt ) 2 dt < +∞ E ]0,T ]

for all Y , Z bounded as in Theorem 1. Such a driver will be called standard. If also Q ∈ L2 (FT ), then the pair (F, Q) will be called standard. We shall assume that the rate matrix A of our chain is left-continuous, and there is an 0 < εr < 1 such that it satisfies ei∗ At ej ∈ [εr , 1/εr ] ∪ {0}

(7)

dt-a.s., for all i and j , i = j . This assumption is satisfied if the chain X is timehomogenous, and essentially states that we shall not consider chains with positive transition rates unbounded or arbitrarily close to zero. Throughout this section, 1 will denote a column vector of appropriate dimension with all components equal to one. We first note that, from the basic properties of stochastic integrals, (see, for example, [19, p. 28]), the following isometry holds. Lemma 1 For any predictable (matrix) process Z (of appropriate dimension), any s < t, 2 2 E Zu dMu Z du = E u Xu− ]s,t]

]s,t]

Lemma 2 For (F, Q) standard, if Y is the solution to (3) given by Theorem 1, then Y satisfies sup E[ Yt 2 ] < +∞

t∈[0,T ]

Lemma 3 For all t, the matrix ψt is symmetric and bounded, and has all row and column sums equal to zero. The matrix given by its Moore-Penrose inverse, ψt+ , is also bounded and has all row and column sums equal to zero. Lemma 4 At each time t, for all j such that ej∗ At Xt− = 0, ψt+ ψt (ej − Xt− ) = ψt ψt+ (ej − Xt− ) = ej − Xt− . Furthermore, the vectors (ej − Xt− ) form a basis for the range of the projections ψt+ ψt and ψt ψt+ .


139

Lemma 5 For any standard driver F , for any Y and Z, up to indistinguishability F (ω, t, Yt− , Zt ) = F (ω, t, Yt− , Zt ψt ψt+ ) and

]0,t]

Zu dMu =

]0,t]

Zu ψu ψu+ dMu .

Therefore, it is no loss of generality to assume that Z = Zψψ + . Lemma 6 Zt Xt− = 0 only if Zt ψt ψt+ = 0. Hence without loss of generality, Zt Xt− = 0 if and only if Zt = 0. Lemma 7 For all t ∈ [0, T ] ψt Xt− = −At Xt− = −

(ej∗ At Xt− )(ej − Xt− ).

(8)

j

Lemma 8 For processes Z solving (3), without loss of generality, the · Xt− norm has two equivalent forms: Zt 2Xt− = Tr(Zt ψt Zt∗ ) (ej∗ At Xt− )[ei∗ Zt (ej − Xt− )]2 . = i,j

Lemma 9 Consider a process Z ∈ R1×N solving a standard, scalar, (K = 1), BSDE of the form of (3). Suppose that for a given t, Zt is such that Zt Xt− = 0, and, for some ε 0 < ε < εr N −3/2 3/2

with εr as in (7), we know −ε Zt Xt− ≤ (ej∗ At Xt− )Zt (ej − Xt− ) for all j . Then Zt ψt Xt− ≤ −ε Zt Xt− .

4 Linear BSDEs Theorem 2 (Linear BSDEs) Let (α, β, γ ) be a du × P-a.s. bounded (RK×N , RK×K , RK ) valued predictable process, φ a predictable RK valued process with E[ ]0,T ] φt 2 dt] < +∞, T a deterministic terminal time and Q a squareintegrable FT measurable RK valued random variable. Then the linear BSDE given by Yt − [φu + βu Yu− + αu Zu∗ γu ]du + Zu dMu = Q (9) ]t,T ]

]t,T ]

140


has a unique square integrable solution (Y, Z), (up to appropriate sets of measure zero). Furthermore, if for all s ∈ [t, T ] I + αs ψs+ (ej − Xs− )γs∗

(10)

ej∗ As Xs−

is invertible for all j such that > 0, except possibly on some evanescent set, then Y is given by the explicit formula T u (11) Yt = E Γt Q + Γt φu du|Ft ]t,T ]

up to indistinguishability. Here Γts is the adjoint process defined for t ≤ s ≤ T by the forward linear SDE s Γt = I + Γtu− [βu du + αu ψu+ dMu γu∗ ]. (12) ]t,s]

Before proving this, we establish the following results: Lemma 10 The adjoint process defined by (12) will satisfy, for t ≤ r ≤ s, Γtr Γrs = Γts . Proof Assume without loss of generality t < s < T . Write dVu = βu du + αu ψu+ dMu γu∗ . Then Γ is defined by the forward SDE Γts

=I +

]t,s]

Γtu− dVu .

If H is Ft measurable in RN ×N , then L = HΓ is the unique solution to

Lst = H +

Suppose t ≤ r and define

Dts

=

]t,s]

for t ≤ s ≤ r for t ≤ r ≤ s.

Γts Γtr Γrs

Then

Lu− t dVu .

Dts = I +

]t,s]

for t ≤ s ≤ r, and

Dtu− dVu

Dts = Γtr + =I +

]r,s]

]t,s]

Dtu− dVu

Dtu− dVu


141

for t ≤ r ≤ s. By uniqueness, for t ≤ r ≤ s, this implies Dts = Γts = Γtr Γrs as desired. In this matrix framework, product integrals are useful, see [17]. In particular, solutions of first-order matrix differential equations can be expressed as product integrals. Lemma 11 Consider a deterministic first-order differential equation of the form t Gu− (13) Gs = I + s Hu du. ]s,t]

Here G and H are K × K matrix-valued functions, H is bounded and Lebesgue integrable, and s < t. Then (13) has an invertible solution, which can be expressed as a product integral, denoted by Gts = Π]s,t] (I + Hu du). If Ht has nonnegative entries off the main diagonal for dt-almost all t, then this solution has all entries nonnegative. Proof As H is bounded and Lebesgue integrable, we can appeal to the theory of the product integral. Using this, n−1

I+ Hu du , (14) Gts = Π]s,t] (I + Hu du) = lim n→∞

](sn )i ,(sn )i+1 ]

i=0

where, for each n, (sn ) is an arbitrary partition of ]s, t] into n parts, s = (sn )0 < (sn )1 < (sn )2 < · · · < (sn )n = t, converging, as n → ∞, in the sense that lim max |(sn )i − (sn )i+1 | = 0,

n→∞

i

indicates products taken sequentially on the right, and the limit is taken in the matrix norm Tr(Gts (Gts )∗ ). This is called the product integral of H , exists by [17, Thm 1], and solves the integral equation (13) by [17, Thm 5]. Gts has an inverse, given by 0

t −1 I− (Gs ) = lim Hu du , (15) n→∞

i=n−1

](sn )i ,(sn )i+1 ]

as noted in [16, p. 134]. Finally, if H has nonnegative entries off the main diagonal dt-a.e., as H is bounded, for sufficiently large n, ](sn )i ,(sn )i+1 ] Hu du has all diagonal entries greater than −1 for all i. Therefore, Hu du I+ ](sn )i ,(sn )i+1 ]

142


is nonnegative for all i. Consequently, the product in (14) must be nonnegative. As the set of matrices with nonnegative components is closed, the limit Π]s,t] (I + Hu du) will also have all components nonnegative. Lemma 12 Let t be a time at which X jumps, that is, ΔXt = 0. Then P(ΔXt = ej − Xt− for some j with ej∗ At Xt− > 0) = 1. Proof This Lemma is quite intuitive – the jump times of a Markov chain are at points where the rate of jumping is nonzero. A formal proof is given in [6]. Lemma 13 Suppose that for all s ∈]t, T ], I + αs ψs+ (ej − Xs− )γs∗ is invertible for all j such that ej∗ As Xs− > 0, except possibly on some evanescent set. Then the adjoint process Γts defined by (12) is invertible (except possibly on this evanescent set). Proof By the definition of M in (1), we can rewrite (12) as (u−) Γts = I + Γtu [βu − αu ψu+ Au Xu− γu∗ ]du + Γt αu ψu+ ΔXu γu∗ . (16) ]t,s]

t 0) = 1. By assumption, I + αs ψs+ (ej − Xs− )γs∗ is invertible for all such j (up to evanescence), and (Γts )−1 = (I + αs ψs+ ΔXs γs∗ )−1 (Γt

(s−) −1

)

.

(18)

The process X almost surely has finitely many jumps in [0, T ]. Through a process of induction using the starting value Γtt = I and equations (17) and (18), we can conclude Γts is invertible (up to evanescence).


143

Theorem 3 Suppose βu − αu ψu+ Au Xu− γu∗ has all nonnegative components off the main diagonal P × du-a.s., for u ∈ ]t, T ], and, except possibly on some evanescent subset of Ω × ]t, T ], I + αu ψu+ (ej − Xu− )γu∗ has nonnegative components for all j such that ej∗ Au Xu− > 0. Then the adjoint process Γts has all entries nonnegative for all s ∈ ]t, T ], up to evanescence. Proof As above, if two consecutive jump times are s0 , s1 , for s ∈ [s0 , s1 [ we have from (16), Γts = Γt 0 Π]s0 ,s] {I + [βu − αu ψu+ Au Xu− γu∗ ]du}. s

By assumption, [βu −αu ψu+ Au Xu− γu∗ ]du has nonnegative components off the main diagonal, and therefore by Lemma 11, Γss0 has nonnegative components. The product of matrices with nonnegative components has nonnegative components, so if s Γt 0 has nonnegative components, Γts has nonnegative components. (s−) At each jump time, we have from (16) that ΔΓts = Γt αs ψs+ ΔXs γs∗ . This implies (s−)

Γts = Γt

(I + αs ψs+ ΔXs γs∗ )

and the term in parentheses has all nonnegative components by our assumption and the argument of Lemma 13 regarding the values of ΔXs . The process X almost surely has finitely many jumps in [0, T ], and therefore through a process of induction using the starting value Γtt = I we conclude that Γts has nonnegative entries up to evanescence. We can then deduce Corollary 1 The conditions of Theorem 3 are necessary for Γts to have all entries nonnegative for all s and t.

Proof See [6]. A useful result when applying this Lemma is the following.

Lemma 14 For a nonnegative column vector x ∈ RK and any basis vector ei ∈ RK , the matrix I + xei∗ has nonnegative components and is invertible. Lemma 15 Under the conditions of Theorem 2, sup E Γ0t 2 < +∞ t

and

t sup E Γ0 Yt + t

]0,t]

2 Γ0u− φu du < +∞.

144


Proof See [6]. We now proceed with the proof of Theorem 2. Proof (Theorem 2) It is clear that (9) is of the form of (3), where F (ω, t, Yt− , Zt ) = φt + βt Yt− + αt Zt γt∗

is a Lipschitz continuous, square integrable driver for the equation. The uniqueness of the solution follows from Theorem 1. We now search for the closed-form solution. The first required result is that t Γ0u φu du Γ0 Yt + ]0,t]

is a uniformly integrable martingale. To see this, observe that in this context all integrals are Stieltjes integrals, and hence t 0 Γ0 Yt = Γ0 Y0 + [Γ0u− dYu + dΓ0u Yu− ] + ΔΓ0u ΔYu ]0,t]

= Γ00 Y0 −

]0,t]

+ +

]0,t]

0 −1,

(19)

as γ = 1, without loss of generality. Theorem 4 (Scalar Comparison Theorem) Suppose we have two standard, scalar (K = 1) BSDEs corresponding to coefficients and terminal values (F 1 , Q1 ) and (F 2 , Q2 ). Let (Y 1 , Z 1 ) and (Y 2 , Z 2 ) be the associated solutions. We suppose the following conditions hold:

146


(i) Q1 ≥ Q2 P-a.s. (ii) dt × P-a.s., 2 2 F 1 (ω, t, Yt− , Zt2 ) ≥ F 2 (ω, t, Yt− , Zt2 ).

(iii) There exists an ε > 0 such that P-a.s., for all t ∈ [0, T ], if Zt1 , Zt2 are such that (ej∗ At Xt− )[Zt1 − Zt2 ](ej − Xt− ) ≥ −ε Zt1 − Zt2 Xt− for all ej , then 2 2 , Zt1 ) − F 1 (ω, t, Yt− , Zt2 ) ≥ −[Zt1 − Zt2 ]At Xt− , F 1 (ω, t, Yt−

with equality only if Zt1 − Zt2 Xt− = 0. It is then true that Y 1 ≥ Y 2 P-a.s. Moreover, this comparison is strict, that is, if on some A ∈ Ft we have Yt1 = Yt2 , then Q1 = Q2 P-a.s. on A, F 1 (ω, s, Ys2 , Zs2 ) = F 2 (ω, s, Ys2 , Zs2 ) ds × P-a.s. on [t, T ] × A and Y 1 is indistinguishable from Y 2 on [t, T ] × A. Remark 2 Note that Assumption (iii) need only hold for Z 1 and Z 2 ; there may well be other processes Z for which it fails. In practise, as Z 1 and Z 2 are typically a priori unknown, it may be more convenient to assume that this Assumption holds for all Z 1 and Z 2 . An intuitive interpretation of this assumption is: Consider the difference between 2 , trend F (ω, t, Y , Z i ), and hedging processes Z 1 the SDEs with starting value Yt− t t t 2 and Zt . If the only sizeable jumps that can occur in this difference are positive, then the overall trend through time, excluding jumps, should be negative. Proof (Theorem 4) We can write 1 2 [F 1 (ω, u, Yu− , Zu1 ) − F 2 (ω, u, Yu− , Zu2 )]du Yt1 − Yt2 − +

]t,T ]

]t,T ]

[Zu1 − Zu2 ]dMu = Q1 − Q2 .

(20)

Taking (20), the equation satisfied by δY := Y 1 − Y 2 and δZ := Z 1 − Z 2 , we shall form an equivalent linear BSDE for δY and apply Corollary 2 to prove the desired result. For notational simplicity, we shall omit the ω, t arguments of F 1 , F 2 as implicit. We also define 0/0 := 0 wherever needed. Without loss of generality, we can assume ε < εr N −3/2 , 3/2

where εr is as in (7). We consider three cases. 2 , Z 1 ) − F 1 (Y 2 , Z 2 ) ≥ 0, then let 1. If F 1 (Yt− t t− t


147

2 2 φt = F 1 (Yt− , Zt1 ) − F 2 (Yt− , Zt2 ), 1 , Z 1 ) − F 1 (Y 2 , Z 1 ) F 1 (Yt− t t− t , δYt− αt = 0,

βt =

γt = 1. 2 , Z 1 ) − F 1 (Y 2 , Z 2 ) ≥ 0 imNote that our Assumption (ii) and the fact F 1 (Yt− t t− t plies that φt ≥ 0. 2 , Z 1 ) − F 1 (Y 2 , Z 2 ) < 0 and there is a j such that 2. If F 1 (Yt− t t− t

(ej∗ At Xt− )[Zt1 − Zt2 ](ej − Xt− ) < −ε Zt1 − Zt2 Xt− , then let 2 2 , Zt2 ) − F 2 (Yt− , Zt2 ), φt = F 1 (Yt− 1 , Z 1 ) − F 1 (Y 2 , Z 1 ) F 1 (Yt− t t− t , δYt− 2 , Z 1 ) − F 1 (Y 2 , Z 2 ) F 1 (Yt− t t− t αt = · ej∗ ψt , [Zt1 − Zt2 ]ψt ej γt = 1.

βt =

2 , Z 1 ) − F 1 (Y 2 , Z 2 ) < 0 and 3. If F 1 (Yt− t t− t

(ej∗ At Xt− )[Zt1 − Zt2 ](ej − Xt− ) ≥ −ε Zt1 − Zt2 Xt−

(21)

for all j , then let 2 2 , Zt2 ) − F 2 (Yt− , Zt2 ), φt = F 1 (Yt− 1 , Z 1 ) − F 1 (Y 2 , Z 1 ) F 1 (Yt− t t− t , δYt− 2 , Z 1 ) − F 1 (Y 2 , Z 2 ) F 1 (Yt− t t− t ∗ αt = · Xt− ψt , [Zt1 − Zt2 ]ψt Xt− γt = 1.

βt =

In all three cases, it is clear that 1 2 F 1 (Yt− , Zt1 ) − F 2 (Yt− , Zt2 ) = φt + βt (δYt− ) + αt (δZt )∗ γt ,

and so the linear BSDE with these values of φt , βt , αt and γt is equivalent to (20). Furthermore, E[ ]0,T ] φt 2 dt] < +∞ as F is standard, and in each case, βt , αt and γt are dt × P-a.s. bounded. This is trivial for γt , and follows directly from Lipschitz continuity for βt in all cases. We need to show this holds for αt . In Case 1, αt = 0. In Case 2, we know that ψt ej = (ej∗ At Xt− )[ej − Xt− ] by the definition of ψ in (4). By assumption, the absolute value of [Zt1 − Zt2 ]ψt ej is then at least ε Zt1 − Zt2 Xt− , and therefore αt is bounded by Lipschitz continuity. 2 , Z 1 ) = F 1 (Y 2 , Z 2 ), we know In Case 3, by Lemma 6 and the fact F 1 (Yt− t t− t 1 2 Zt − Zt Xt− = 0, and so we are in precisely the situation considered in Lemma 9.

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Therefore [Zt1 − Zt2 ]ψt Xt− < −ε Zt1 − Zt2 Xt− , and so Lipschitz continuity implies the boundedness of αt in Case 3. We have assumed that F 1 and F 2 are standard, and hence P-a.s. left continuous i and Z i for i = 1, 2 by construction, we see that the variable C indiin t, as are Yt− t t cating which of Cases 1, 2 and 3 is in force at any time t is predictable. Furthermore, the processes α, β and φ defined in each case are also predictable. We then use Ct to piece together the various definitions of α β and φ to give a single predictable 1 , Z 1 ) − F 2 (Y 2 , Z 2 ) dt × P-a.s. linear BSDE, with the same driver values as F 1 (Yt− t t− t This linear BSDE satisfies all the requirements for Theorem 2. We now appeal to Remark 1 to determine that the only requirement to show nonnegativity of δY is that, for all t, αt ψt+ (ek − Xt− ) > −1 for all k with ek∗ At− Xt− > 0. In Case 1 this is clear. In Case 2, we can write αt ψt+ (ek − Xt− ) =

2 , Z 1 ) − F 1 (Y 2 , Z 2 ) F 1 (Yt− t t− t

ej∗ ψt [Zt1 − Zt2 ]∗

ej∗ ψt ψt+ (ek − Xt− )

and, by Lemma 4, ej∗ ψt ψ + (ek − Xt− ) = ej∗ (ek − Xt− ), which is zero unless k = j . If k = j we see that αt ψt+ (ek − Xt− ) =

2 , Z 1 ) − F 1 (Y 2 , Z 2 ) F 1 (Yt− t t− t

ej∗ ψt [Zt1 − Zt2 ]∗

>0

by construction. In Case 3, we know from Lemma 9 that [Zt1 − Zt2 ]ψt Xt− is negative. For any k satisfying Lemma 4, this implies ∗ ψ ψ + (e − X ) Xt− t t k t− ∗ ψ [Z 1 − Z 2 ]∗ Xt− t t t

=

∗ (e − X ) Xt− k t− ∗ ψ [Z 1 − Z 2 ]∗ Xt− t t t

is positive. We then use Assumption (iii) of the theorem, along with Lemma 7, to show that, αt ψ + (ek − Xt− ) 2 , Z 1 ) − F 1 (ω, t, Y 2 , Z 2 ) F 1 (ω, t, Yt− t t− t ∗ = Xt− (ek − Xt− ) 1 2 [Zt − Zt ]ψt Xt− >−

[Zt1 − Zt2 ]At Xt− ∗ Xt− (ek − Xt− ) [Zt1 − Zt2 ]ψt Xt−

[Zt1 − Zt2 ]ψt Xt− [Zt1 − Zt2 ]ψt Xt− = −1, =−

as desired. Therefore, we have shown that δY = Y 1 − Y 2 , the difference of our processes, satisfies the requirements of Remark 1. That is, the assumptions of Corollary 2 are satisfied by this process and δY is therefore nonnegative P-a.s. The rest of the theorem also follows by Corollary 2.


149

Remark 3 In general Assumption (iii) cannot be omitted, and is closely related to various geometric interpretations of no arbitrage. The fact that it is possible to create such Z 1 and Z 2 , (due to the linear redundancy in M), indicates a significant difference between the Markov chain theory considered here and that based on Brownian motion considered elsewhere. Examples can be given that show the comparison theorem does not hold when any of the assumptions of Theorem 4 are violated. See [6].

6 General Comparison Theorems We now wish to extend Theorem 4 to the vector case. This is nontrivial, as the simplifications of Remark 1 are not possible, and we must satisfy the more difficult conditions of Corollary 2 directly. We also do not have the useful result of Lemma 9. We present here, without proof, some alternative generalisations. (Proofs are given in [6].) Theorem 5 (Vector Comparison Theorem 1) Suppose we have two standard BSDE parameters (F 1 , Q1 ) and (F 2 , Q2 ). Let (Y 1 , Z 1 ) and (Y 2 , Z 2 ) be the associated solutions. Recall the dimensions of each of the terms in our BSDEs: F (ω, t, Yt− , Zt ), Yt− , Q ∈ RK and Zt ∈ RK×N , where N is the number of states of the Markov chain X. We suppose the following conditions hold: (i) Q1 ≥ Q2 P-a.s. (ii) dt × P-a.s., 2 2 , Zt2 ) ≥ F 2 (ω, t, Yt− , Zt2 ). F 1 (ω, t, Yt−

(iii) There exists an ε > 0 such that P-a.s., for all t ∈ [0, T ], for any basis vector ek ∈ RK , if Zt1 , Zt2 are such that (ej∗ At Xt− )ek∗ [Zt1 − Zt2 ](ej − Xt− ) ≥ −ε ek∗ [Zt1 − Zt2 ] Xt− for all ej , then 2 2 ek∗ [F 1 (ω, t, Yt− , Zt1 ) − F 1 (ω, t, Yt− , Zt2 )] ≥ −ek∗ [Zt1 − Zt2 ]At Xt−

with equality only if ek∗ [Zt1 − Zt2 ] Xt− = 0. (iv) For each i, ei∗ F 1 can be written as a function ei∗ F 1 (ω, t, Yt− , Zt ) = Fi1 (ω, t, ei∗ Yt− , ei∗ Zt ), that is, the ith component of F 1 is depends only on the ith component of Y and the ith row of Z (and ω and t). It is then true that Y 1 ≥ Y 2 P-a.s. Moreover, this comparison is strict, that is, if on some A ∈ Ft we have Yt1 = Yt2 , then Q1 = Q2 P-a.s. on A, F 1 (ω, s, Ys2 , Zs2 ) = F 2 (ω, s, Ys2 , Zs2 ) ds × P-a.s. on [t, T ] × A and Y 1 is indistinguishable from Y 2 on [t, T ] × A.

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Corollary 3 For any pair of BSDEs satisfying Assumption (iv) of Theorem 5, if Assumptions (i)–(iii) are satisfied by any component of the terminal condition and driver, then the comparison theorem will hold on that component. It is clear that this theorem does not provide for much more behaviour than the scalar case, as it is considering each component separately from the others. Removing this requirement is nontrivial, but can be done. To do so using the machinery of the solutions to linear BSDEs, we must make the following, in some sense stronger, assumption. Theorem 6 (Vector Comparison Theorem 2) Suppose we have two standard BSDE parameters (F 1 , Q1 ) and (F 2 , Q2 ). Let (Y 1 , Z 1 ) and (Y 2 , Z 2 ) be the associated solutions, where the dimensions of F , Q, Y and Z are as in Theorem 5. We suppose the following conditions hold: (i) Q1 ≥ Q2 P-a.s. (ii) dt × P-a.s., 2 2 F 1 (ω, t, Yt− , Zt2 ) ≥ F 2 (ω, t, Yt− , Zt2 ).

(iii) There exists an ε > 0 such that, P-a.s., for all t ∈ [0, T ], for any basis vector ej ∈ RK , if (ek∗ At Xt− )ej∗ [Zt1 − Zt2 ](ek − Xt− ) ≥ −ε Zt1 − Zt2 Xt− for all ek = Xt− , then 2 2 ej∗ [F 1 (ω, t, Yt− , Zt1 ) − F 1 (ω, t, Yt− , Zt2 )] ≥ 0.

(iv) For each i, ei∗ F 1 can be written as a function ei∗ F 1 (ω, t, Yt− , Zt ) = Fi1 (ω, t, ei∗ Yt− , Zt ), that is, the ith component of F 1 depends only on the ith component of Y (and on ω, t and Zt ). It is then true that Y 1 ≥ Y 2 P-a.s. Moreover, this comparison is strict, that is, if on some A ∈ Ft we have Yt1 = Yt2 , then Q1 = Q2 P-a.s. on A, F 1 (ω, s, Ys2 , Zs2 ) = F 2 (ω, s, Ys2 , Zs2 ) ds × P-a.s. on [t, T ] × A and Y 1 is indistinguishable from Y 2 on [t, T ] × A. Remark 4 The key differences between Theorem 6 and Theorem 5 are that in Theorem 6, a weaker assumption is placed on the behaviour of the driver in relation to interactions between the rows of the Z matrix, but a stronger assumption is placed on the behaviour of a component of F when no jump is significantly negative in that component. Assumption (iii) in Theorem 6 is a stronger assumption than for Theorem 5. In the scalar case, which is the foundation of Theorem 5, we used Lemma 9 to show that each row ei∗ [Zt1 − Zt2 ]ψt Xt− is negative, and our assumption was equivalent to 2 2 , Zt1 ) − F 1 (ω, t, Yt− , Zt2 )] ≥ ek∗ [Zt1 − Zt2 ]ψt Xt− , ek∗ [F 1 (ω, t, Yt−


151

which is clearly satisfied when 2 2 ek∗ [F 1 (ω, t, Yt− , Zt1 ) − F 1 (ω, t, Yt− , Zt2 )] ≥ 0.

The assumption that the ith component of F can depend only on the ith component of Y may be overly restrictive. Because of this, we have the following alternative generalisation, where we instead assume that F does not depend on Z. Theorem 7 (Vector Comparison Theorem 3) Suppose we have two standard BSDE parameters (F 1 , Q1 ) and (F 2 , Q2 ). Let (Y 1 , Z 1 ) and (Y 2 , Z 2 ) be the associated solutions. We suppose the following conditions hold: (i) Q1 ≥ Q2 P-a.s. (ii) dt × P-a.s., 2 2 F 1 (ω, t, Yt− , Zt2 ) ≥ F 2 (ω, t, Yt− , Zt2 ).

(iii) There exists an ε > 0 such that, dt × P-a.s., for each i, if 1 2 ei∗ F 1 (ω, t, Yt− , Zt ) < ei∗ F 1 (ω, t, Yt− , Zt )

then either 1 2 1 2 |ei∗ [Yt− − Yt− ]| > ε Yt− − Yt−

or there is a j with 1 2 1 2 ej∗ [Yt− − Yt− ] < −ε Yt− − Yt− .

(iv) F 1 does not depend on Z. It is then true that Y 1 ≥ Y 2 P-a.s. Moreover, this comparison is strict, that is, if on some A ∈ Ft we have Yt1 = Yt2 , then Q1 = Q2 P-a.s. on A, F 1 (ω, s, Ys2 , Zs2 ) = F 2 (ω, s, Ys2 , Zs2 ) ds × P-a.s. on [t, T ] × A and Y 1 is indistinguishable from Y 2 on [t, T ] × A. This theorem is counterintuitive, and when examined closely would appear to create a contradiction. The only resolution to this is the following corollary. Corollary 4 For a pair of BSDEs satisfying Theorem 7, the strict comparison must hold componentwise. That is, if for some t and some ei , on some A ∈ Ft we have ei∗ Yt1 = ei∗ Yt2 , then ei∗ Q1 = ei∗ Q2 P-a.s. on A, ei∗ F 1 (ω, s, Ys2 , Zs2 ) = ei∗ F 2 (ω, s, Ys2 , Zs2 ) ds × P-a.s. on [t, T ] × A and ei∗ Y 1 is indistinguishable from ei∗ Y 2 on [t, T ] × A.

7 F -Expectations One interpretation of the solution to a BSDE is as a type of generalised expectation. In particular, for a fixed standard driver F and Q ∈ RK an Ft measurable, square integrable random variable, we can define the conditional F -evaluation to be F Es,t (Q) = Ys

(22)

152


for s ≤ t, where Ys is the solution to Ys − F (ω, u, Yu− , Zu )du + ]s,t]

]s,t]

Zu dMu = Q.

Definition 1 Following [22], we shall call a system of operators Es,t : L2 (Ft ) → L2 (Fs ), 0 ≤ s ≤ t ≤ T an Ft -consistent nonlinear evaluation for {Qs,t ⊂ L2 (Ft )|0 ≤ s ≤ t ≤ T } defined on [0, T ] if it satisfies the following properties. 1. For Q, Q ∈ Qs,t , Es,t (Q) ≥ Es,t (Q ) P-a.s. componentwise whenever Q ≥ Q P-a.s. componentwise, with equality iff Q = Q P-a.s. 2. Et,t (Q) = Q P-a.s. 3. Er,s (Es,t (Q)) = Er,t (Q) P-a.s. for any r ≤ s ≤ t. 4. For any A ∈ Fs , IA Es,t (Q) = IA Es,t (IA Q) P-a.s. We consider here a significant generalisation of [22], as our evaluations can all be vector valued, provided they are square integrable. This generalisation allows the use of these evaluations in multi-objective problems, where a scalar evaluation process may be insufficient. We also only require these properties to hold on some subset Qs,t of the set of square integrable terminal conditions, a distinction which shall become important when we consider arbitrage and finite market modelling. Note however that Es,t is defined over the whole of L2 (Ft ), but it is only on Qst that Property 1 holds. Furthermore, we add the restriction that if Q ≥ Q P-a.s., Q, Q ∈ Qt , then Es,t (Q) = Es,t (Q ) P-a.s. iff Q = Q P-a.s. Remark 5 If Es,t is an Ft -consistent nonlinear evaluation for Qs,t , it is also an Ft -consistent nonlinear evaluation for any subset of Qs,t . Definition 2 We often wish for the sets {Qs,t } to be stable through time. That is, E will be called dynamically monotone for {Qs,t } if and only if, for all r ≤ s ≤ t, (i) E is an Ft consistent nonlinear evaluation for {Qs,t }, (ii) Qr,t ⊆ Qs,t , (Qs,t is nondecreasing in s), (iii) Es,t (Q) ∈ Qr,s for all Q ∈ Qr,t . Remark 6 In an economic context, where Es,t represents the price at s of an asset to be sold at time t, dynamic monotonicity corresponds, in some sense, to the statements (ii) “An asset with an arbitrage free price, when bought at a time r and sold at time t, should also have an arbitrage free price when bought at any time s following r, (with s prior to t),” and


153

(iii) “An asset with an arbitrage free price, when the asset is bought at a time r and sold at time t, should be arbitrage free when sold at any time s prior to t, (with s following r).” Theorem 8 Fix a driver F . Consider a collection of sets {Qs,t ⊂ L2 (Ft )} with Qr,t ⊆ Qs,t for all r ≤ s ≤ t. Suppose that, for any Q1 , Q2 ∈ Qs,t , at least one of Theorems 4, 5, 6 and 7 holds on [s, t], with F 1 = F 2 = F , whenever Q1 ≥ Q2 F defined in (22) is an F -consistent nonlinear evaluation for {Q }. P-a.s. Then Es,t t s,t Proof F (Q ) ≥ E F (Q ) P-a.s. whenever Q ≥ Q P-a.s. is simply 1. The statement Es,t 1 2 1 2 s,t the main result of each comparison theorem, one of which holds by assumption. The strict comparison then establishes the second statement. F (Q) = Q, P-a.s. for any F measurable Q is trivial, as we have 2. The fact Et,t t F defined Et,t (Q) by the solution to a BSDE, which reaches its terminal value Q at time t by construction. 3. For any r ≤ s ≤ t, let Y denote the solution to the relevant BSDE. Then we have F (ω, u, Yu− , Zu )du + Zu dMu Q = Yr − ]r,t]

which implies Ys = Yr −

]r,t]

]r,s]

F (ω, u, Yu− , Zu )du +

]r,s]

Zu dMu .

Hence Yr is also the time r value of a solution to the BSDE with terminal time s and value Ys . Hence F F F Er,s (Es,t (Q)) = Er,t (Q)

P-a.s. as desired. 4. We wish to show that for A ∈ Fs , IA Es,t (Q) = IA Es,t (IA Q) P-a.s. Write Es,t (Q) as the solution to the BSDE with terminal value Q, and Es,t (IA Q) as the solution to the BSDE with terminal value IA Q. Premultiplying these BSDEs by IA gives two BSDEs, both with terminal value IA Q, driver F˜ (ω, t, Yt , Zt ) = IA F (ω, t, Yt , Zt ) = IA F (ω, t, IA Yt , IA Zt ), and solutions IA Es,t (Q) and IA Es,t (IA Q) respectively. From Theorem 1, the solution to this BSDE is unique, hence IA Es,t (Q) = IA Es,t (IA Q) up to indistinguishability. Definition 3 Let {Qs,t ⊂ L2 (Ft )} be a family of sets which are nondecreasing in s. For a BSDE driver F 1 , suppose that, for all s ≤ t ≤ T , Assumption (iii), (and Assumption (iv), when applicable), of at least one of Theorems 4, 5, 6 and 7 hold on ]s, t] for all Q1 , Q2 ∈ Qs,t , (whether or not Assumption (i) holds). Then F 1 is said to be a balanced driver on {Qs,t }.

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Remark 7 The logic of this name is due to the geometry of the problem, as, in some sense, F 1 here ‘balances’ the outcomes with zero hedging within the range of outcomes with hedging. Lemma 16 Let F be a balanced driver on {Qs,t }, where Qs,t is nondecreasing in s. Then E F is an Ft consistent nonlinear evaluation on {Qs,t }. Proof The requirements for F to be balanced are stronger than those needed for Theorem 8, and so the result follows. Definition 4 Again following [22], we shall call a system of operators E (.|Ft ) : L2 (FT ) → L2 (Ft ), 0 ≤ t ≤ T an Ft -consistent nonlinear expectation for {Qt ⊂ L2 (FT )} defined on [0, T ] if it satisfies the following properties. 1. For Q, Q ∈ Qt , E (Q|Ft ) ≥ E (Q |Ft ) P-a.s. componentwise whenever Q ≥ Q P-a.s. componentwise, with equality iff Q = Q P-a.s. 2. E (Q|Ft ) = Q P-a.s. for any Ft measurable Q. 3. E (E (Q|Ft )|Fs ) = E (Q|Fs ) P-a.s. for any s ≤ t. 4. For any A ∈ Ft , IA E (Q|Ft ) = E (IA Q|Ft ) P-a.s. Remark 8 It is clear that any nonlinear expectation is also a nonlinear evaluation, with Es,t (·) = E (·|Fs ) for all s ≤ t, and hence the concept of dynamic monotonicity extends to this new setting. On the other hand, as the terminal time is irrelevant in this context, one can simply specify the sets Qt = QtT , as the expectation refers without loss of generality to the terminal values at time T . Therefore, we say E (·|Ft ) is dynamically monotone for {Qt } if, for all s ≤ t, (i) E is an Ft consistent nonlinear expectation for {Qt }, (ii) Qs ⊆ Qt , (Qt is nondecreasing in t), (iii) E (Q|Ft ) ∈ Qs for all Q ∈ Qs . Theorem 9 Fix a driver F such that F (ω, t, Yt− , 0) = 0 dt × P-a.s. Consider a family of sets {Qt ⊂ L2 (FT )} such that for any Q, Q ∈ Qt with Q ≥ Q , at least one of Theorems 4, 5, 6 and 7 holds on ]t, T ] with F 1 = F 2 = F . The functional E F (.|Ft ) defined for each t by E F (Q|Ft ) = Yt , where Yt is the solution to Yt − F (ω, u, Yu− , Zu )du + ]t,T ]

]t,T ]

is an Ft -consistent nonlinear expectation for {Qt }.

(23)

Zu dMu = Q,


155

Proof Properties 1 and 3 follow exactly as in the proof of Theorem 8. Property 2 follows because we know that for t < T , if Q is Ft measurable then the solution of Yt − F (ω, u, Yu− , Zu )du + Zu dMu = Q ]t,T ]

]t,T ]

has Zu = 0 dM, Mu × P-a.s. (Simply take an Ft conditional expectation as done earlier.) Hence for t ≤ u ≤ T , F (ω, u, Yu− , Zu ) = 0, and therefore Yt = Q, P-a.s., as desired. For Property 3, we know that IA E (Q|Ft ) is the solution to a BSDE with terminal value IA Q and driver IA F (ω, t, Y, Z). As F (ω, t, Yt− , 0) = 0, IA F (ω, t, Y, Z) = F (ω, t, Y, IA Z), P-a.s. We also know E (IA Q|Ft ) is the solution to a BSDE with driver F , and taking an Ft conditional expectation shows that the solution Z process for E (IA Q|Ft ) satisfies Z = IA Z. Hence the two quantities solve the same BSDE, and so by the uniqueness of Theorem 1 must be equal.

8 Applications to Risk Measures One use of BSDEs which has developed recently is as a framework for developing dynamically consistent, convex or coherent risk measures. This can be seen in [3], and more generally in [23]. We here present the key results in the context of BSDEs driven by Markov Chains. As noted in [22], the theory of nonlinear expectations provides an ideal setting for the discussion of risk measures in the sense of [1] and others. We shall consider dynamic risk measures tF of the form F (Q) tF (Q) := −Et,T

where E F is a nonlinear F -evaluation for some {Qs,T ⊂ L2 (FT )}. As before, our approach allows a considerable generalisation of earlier results, as the quantities considered can be vector valued. F (−Q), An alternative specification, used in [3] and [23], is to let tF (Q) = Et,T the solution to a BSDE with terminal condition −Q. Under this alternative specification, the following results remain valid, however the result of Theorem 13 holds for with F convex rather than concave. F , which are particWe seek to determine properties of tF , or equivalently of Et,T ularly relevant in the context of risk measures. The first four properties below follow directly from the properties of nonlinear evaluations, recalling the proofs of Theorems 8 and 9, with Qt = ∅ where appropriate. Lemma 17 (Terminal Equality) For any F , tF satisfies the terminal condition TF (Q) = −Q. Proof Equivalent to Property 2 of nonlinear evaluations.

156


Theorem 10 (Dynamic Consistency) For any F , tF satisfies the recursivity and dynamic consistency requirements sF (Q) = sF (−tF (Q)) and tF (Q) = tF (Q ) ⇒ sF (Q) = sF (Q ) for times s ≤ t ≤ T , all equalities being P-a.s. Proof The first statement is equivalent to Property 3 of nonlinear evaluations. The second follows by uniqueness of solutions to BSDEs with given terminal conditions, as in Theorem 1. Lemma 18 (Constants) Let Q be P-a.s. equal to a Ft measurable terminal condition. Then if F is a driver with normalisation F (ω, t, Q, 0) = 0 dt × P-a.s., tF (Q) = −Q for all t.

Proof Equivalent to Property 4 of nonlinear expectations.

Theorem 11 (Monotonicity) Let F be a balanced driver for {Qt,T }. Then for any Q1 , Q2 ∈ Qt,T with Q1 ≥ Q2 P-a.s., we have tF (Q1 ) ≤ tF (Q2 ), with equality if and only if Q1 = Q2 , P-a.s.

Proof Equivalent to Property 1 of nonlinear evaluations.

Lemma 19 (Translation invariance) Let F be a driver for a BSDE with normalisation F (ω, u, Yu− , 0) = 0 P × du-a.s. on ]t, T ]. Suppose F does not depend on Ys− . Then for any q ∈ L2 (Ft ), tF (Q + q) = tF (Q) − q F (Q + q) = Et,T (Q) + q Et,T

Proof As F does not depend on Yu− , we know that Yt − F (ω, u, Yu− , Zu )du + ]t,T ]

implies [Yt + q] −

]t,T ]

Zu dMu = Q

]t,T ]

F (ω, u, [Yu− + q], Zu )du +

]t,T ]

Zu dMu = [Q + q].

The result follows.

Theorem 12 (Positive Homogeneity) Let F be a positively homogeneous driver, that is, for any λ > 0, if (Y, Z) is the solution corresponding to some Q, P × du-a.s. on ]t, T ], F (ω, u, λYu− , λZu ) = λF (ω, u, Yu− , Zu ).


157

F (λQ) = λE F (Q). Then for all such Q, tF (λQ) = λtF (Q) and Et,T t,T

Proof Simply multiply the BSDE with terminal condition Q through by λ.

Theorem 13 (Convexity/Concavity) Suppose Qt,T is a convex set. Let F be a concave balanced driver for Qt,T , that is, for any λ ∈ [0, 1], any (Y 1 , Z 1 ), (Y 2 , Z 2 ) the solutions corresponding to Q1 , Q2 ∈ Qt,T , P × du-a.s. on ]t, T ], 1 2 F (ω, u, λYu− + (1 − λ)Yu− , λZu1 + (1 − λ)Zu2 ) 1 2 , Zu ) + (1 − λ)F (ω, u, Yu− , Zu2 ). ≥ λF (ω, u, Yu−

Then for any λ ∈ [0, 1] and any Q1 , Q2 ∈ Qt,T , tF (λQ1 + (1 − λ)Q2 ) ≤ λtF (Q1 ) + (1 − λ)tF (Q2 ), F F F Et,T (λQ1 + (1 − λ)Q2 ) ≥ λEt,T (Q1 ) + (1 − λ)Et,T (Q2 ).

Proof Taking a convex combination of the BSDEs with terminal conditions Q1 and Q2 gives the equation 1 2 1 2 λYt + (1 − λ)Yt − [λF (ω, u, Yu− , Zu ) + (1 − λ)F (ω, u, Yu− , Zu2 )]du ]t,T ] [λZu1 + (1 − λ)Zu2 ]dMu = λQ1 + (1 − λ)Q2 , + ]t,T ]

which is a BSDE with terminal condition λQ1 − (1 − λ)Q2 and driver 1 2 , Zu ) + (1 − λ)F (ω, u, Yu− , Zu2 ). F˜ = λF (ω, u, Yu−

We next consider the BSDE with terminal condition λQ1 + (1 − λ)Q2 and driver F . Denote the solution to this by Y λ . We can compare these BSDEs using the relevant comparison theorem – the first assumption of the theorem is trivial, the second is satisfied by the convexity of F , and the remaining because F is balanced on Qt,T . Hence, our solutions satisfy Y λ ≥ λY 1 + (1 − λ)Y 2 with equality if and only if the terminal conditions are equal with conditional probaF follows. The inequality for F can then be estabbility one. The inequality for Et,T t F (Q) is concave in Q, it follows that F (Q) = −E F (Q) lished by noting that as Et,T t t,T is convex in Q.

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3. Barrieu, P., El Karoui, N.: Optimal derivatives design under dynamic risk measures. In: Yin, G., Zhang, Q. (eds.) Mathematics of Finance. Contemporary Mathematics, vol. 351, pp. 13– 26. AMS, Providence (2004) 4. Becherer, D.: Bounded solutions to backward SDE’s with jumps for utility optimization and indifference hedging. Ann. Appl. Probab. 16(4), 2027–2054 (2006) 5. Cohen, S.N., Elliott, R.J.: Solutions of backward stochastic differential equations on Markov chains. Commun. Stoch. Anal. 2(2), 251–262 (2008) 6. Cohen, S.N., Elliott, R.J.: Comparisons for backward stochastic differential equations on Markov chains and related no-arbitrage conditions. Ann. Appl. Probab. 20(1), 267–311 (2010) 7. Cohen, S.N., Elliott, R.J.: A general theory of infinite state backward stochastic difference equations. Stoch. Process. Appl. 120(4), 442–466 (2010) 8. Coquet, F., Hu, Y., Memin, J., Peng, S.: Filtration consistent nonlinear expectations and related g-expectations. Probab. Theory Relat. Fields 123(1), 1–27 (2002) 9. Delbaen, F., Peng, S., Rosazza Gianin, E.: Representation of the penalty term of dynamic concave utilities. Working Paper. Available at 0802.1121 (2008) 10. Duffie, D., Epstein, L.G.: Asset pricing with stochastic differential utility. Rev. Financ. Stud. 5(3), 411–436 (1992) 11. El Karoui, N., Peng, S., Quenez, M.: Backward stochastic differential equations in finance. Math. Finance 7(1), 1–71 (1997) 12. El Otmani, M.: Backward stochastic differential equations associated with Lévy processes and partial integro-differential equations. Commun. Stoch. Anal. 2(2), 277–288 (2008) 13. Elliott, R.J.: Stochastic Calculus and its Applications. Springer, Berlin (1982) 14. Elliott, R.J., Aggoun, L., Moore, J.: Hidden Markov Models: Estimation and Control. Springer, Berlin (1994) 15. Föllmer, H., Schied, A.: Stochastic Finance: An Introduction in Discrete Time. Studies in Mathematics, vol. 27. de Gruyter, Berlin (2002) 16. Gantmacher, F.: Matrix Theory, vol. 2. Chelsea, New York (1960) 17. Gill, R.D., Johansen, S.: A survey of product-integration with a view toward application in survival analysis. Ann. Stat. 18(4), 1501–1555 (1990) 18. Hu, Y., Ma, J., Peng, S., Yao, S.: Representation theorems for quadratic F -consistent nonlinear expectations. Stoch. Process. Appl. 118, 1518–1551 (2008) 19. Jacod, J., Shiryaev, A.N.: Limit Theorems for Stochastic Processes. Grundlehren der mathematischen Wissenschaften, vol. 288. Springer, Berlin (2003) 20. Lin, Q.Q.: Nonlinear Doob-Meyer decomposition with jumps. Acta Math. Sin. Engl. Ser. 19(1), 69–78 (2003) 21. Peng, S.: A generalized dynamic programming principle and Hamilton-Jacobi-Bellman equation. Stoch. Stoch. Rep. 38, 119–134 (1992) 22. Peng, S.: Dynamically consistent nonlinear evaluations and expectations. Preprint No. 2004-1, Institute of Mathematics, Shandong University. Available at math/0501415 (2005) 23. Rosazza Gianin, E.: Risk measures via g-expectations. Insur. Math. Econ. 39, 19–34 (2006) 24. Royer, M.: Backward stochastic differential equations with jumps and related non-linear expectations. Stoch. Process. Appl. 116(10), 1358–1376 (2006)

Results on Numerics for FBSDE with Drivers of Quadratic Growth Peter Imkeller, Gonçalo Dos Reis, and Jianing Zhang

Abstract We consider the problem of numerical approximation for forward-backward stochastic differential equations with drivers of quadratic growth (qgFBSDE). To illustrate the significance of qgFBSDE, we discuss a problem of cross hedging of an insurance related financial derivative using correlated assets. For the convergence of numerical approximation schemes for such systems of stochastic equations, path regularity of the solution processes is instrumental. We present a method based on the truncation of the driver, and explicitly exhibit error estimates as functions of the truncation height. We discuss a reduction method to FBSDE with globally Lipschitz continuous drivers, by using the Cole-Hopf exponential transformation. We finally illustrate our numerical approximation methods by giving simulations for prices and optimal hedges of simple insurance derivatives.

1 Introduction Owing to their central significance in optimization problems for instance in stochastic finance and insurance, backward stochastic differential equations (BSDE), one of the most efficient tools of stochastic control theory, have been receiving much attention in the last 15 years. A particularly important class, BSDE with drivers of quadratic growth, for example, arise in the context of utility optimization problems on incomplete markets with exponential utility functions, or alternatively in P. Imkeller () · J. Zhang Department of Mathematics, Humboldt University Berlin, Unter den Linden 6, 10099 Berlin, Germany e-mail: [email protected] J. Zhang e-mail: [email protected] G. Dos Reis CMAP, École Polytechnique, Route de Saclay, 91128 Palaiseau Cedex, France e-mail: [email protected] C. Chiarella, A. Novikov (eds.), Contemporary Quantitative Finance, DOI 10.1007/978-3-642-03479-4_9, © Springer-Verlag Berlin Heidelberg 2010

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questions related to risk minimization for the entropic risk measure. BSDE provide the genuinely stochastic approach of control problems which find their analytical expression in the Hamilton-Jacobi-Bellman formalism. BSDE with drivers of this type keep being a source of intensive research. As Monte-Carlo methods to simulate random processes, numerical schemes for BSDE provide a robust method for simulating and approximating solutions of control problems. Much has been done in recent years to create schemes for BSDE with Lipschitz continuous drivers (see [4] or [9] and references therein). The numerical approximation of BSDE with drivers of quadratic growth (qgBSDE) or systems of forward-backward stochastic equations with drivers of this kind (qgFBSDE) turned out to be more complicated. Only recently, in [7], one of the main obstacles was overcome. Following [4] in the setting of Lipschitz drivers, the strategy to prove convergence of a numerical approximation combines two ingredients: regularity of the trajectories of the control component of a solution pair of the BSDE in the L2 sense, a tool first investigated in the framework of globally Lipschitz BSDE by [19], and a convenient a priori estimate for the solution. See [4, 6, 11] or [3] for numerical schemes of BSDE with globally Lipschitz continuous drivers, and an implementation of these ideas. The main difficulty treated in [7] consisted of establishing path regularity for the control component of the solution pair of the qgBSDE. For this purpose, the control component, known to be represented by the Malliavin trace of the other component, had to be thoroughly investigated in a subtle and complex study of Malliavin derivatives of solutions of BSDE. This study extends a thorough investigation of smoothness of systems of FBSDE by methods based on Malliavin’s calculus and BMO martingales independently conducted in [1] and [5]. The knowledge of path regularity obtained this way is implemented in a second step of the approach in [7]. The quadratic growth part of the driver is truncated to create a sequence of approximating BSDE with Lipschitz continuous drivers. Path regularity is exploited to explicitly capture the convergence rate for the solutions of the truncated BSDE as a function of the truncation height. The error estimate for the truncation, which is of high polynomial order, combines with the ones for the numerical approximation in any existent numerical scheme for BSDE with Lipschitz continuous drivers, to control the convergence of a numerical scheme for qgBSDE. It allows in particular to establish the convergence order for the approximation of the control component in the solution process. An elegant way to avoid the difficulties related to drivers of quadratic growth, and to fall back into the setting of globally Lipschitz ones, consists of using a coordinate transform well known in related PDE theory under the name “exponential Cole-Hopf transformation”. The transformation eliminates the quadratic growth of the driver in the control component at the cost of producing a transformed driver of a new BSDE which in general lacks global Lipschitz continuity in the other component. This difficulty can be avoided by some structure hypotheses on the driver. Once this is done, the transformed BSDE enjoys global Lipschitz continuity properties. Therefore the problem of numerical approximation can be tackled in the framework of transformed coordinates by schemes well known in the Lipschitz setting. As stated before, this again requires path regularity results in the L2 -sense for the

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control component of the solution pair of the transformed BSDE. For globally Lipschitz continuous drivers [19] provides path regularity under simple and weak additional assumptions such as 12 -Hölder continuity of the driver in the time variable. The smoothness of the Cole-Hopf transformation allows passing back to the original coordinates without losing path regularity. In summary, if one accepts the additional structural assumptions on the driver, the exponential transformation approach provides numerical approximation schemes for qgBSDE under weaker smoothness conditions for the driver. In this paper we aim to give a survey of these two approaches to obtain numerical results for qgBSDE. Doing this, we always keep an eye on one of the most important applications of qgBSDE, which consists of providing a genuinely probabilistic approach to utility optimization problems for exponential utility, or equivalently risk minimization problems with respect to the entropic risk measure, that lead to explicit descriptions of prices and hedges. We motivate qgBSDE by reviewing a simple exponential utility optimization problem resulting from a method to determine the utility indifference price of an insurance related asset in a typical incomplete market situation, following [1] and [10]. The setting of the problem allows in particular the calculation of the driver of quadratic growth of the associated BSDE. After discussing the problem of numerical approximations, in this case by applying the method related to the exponential transform, we are finally able to illustrate our findings by giving some numerical simulations obtained with the resulting scheme. The paper is organized as follows. In Sect. 2 we fix the notation used for treating problems about qgFBSDE and recall some basic results. Section 3 is devoted to presenting utility optimization problems used for pricing and hedging derivatives on non-tradable underlyings using correlated assets in a utility indifference approach. In Sect. 4.2 we review smoothness results for the solutions processes of qgFBSDE, and apply them to show L2 -regularity of the control component of the solution process of a qgFBSDE. In Sect. 5 we discuss the truncation method for the quadratic terms of the driver to derive a numerical approximation scheme for qgFBSDE. Section 6 is reserved for a discussion of the applicability of the exponential transform in the qgBSDE setting. In Sect. 7 we return to the motivating pricing and hedging problem and use it as a platform for illustrating our results by numerical simulations.

2 Preliminaries Fix T ∈ R+ = [0, ∞). We work on the canonical Wiener space (Ω, F , P) on which a d-dimensional Wiener process W = (W 1 , . . . , W d ) restricted to the time interval [0, T ] is defined. We denote by F = (Ft )t∈[0,T ] its natural filtration enlarged in the usual way by the P-zero sets. Let p ≥ 2, m, d ∈ N, Q be a probability measure on (Ω, F ). We use the symbol EQ for the expectation with respect to Q, and omit the superscript for the canonical

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measure P. To denote the stochastic integral process of an adapted process Z with · respect to the Wiener process on [0, T ], we write Z ∗ W = 0 Zs dWs . i 2 12 For vectors x =(x 1 , . . . , x m) in Euclidean space Rm we denote |x|=( m i=1 (x ) ) . In our analysis the following normed vector spaces will play a role. We denote by • Lp (Rm ; Q) the space of FT -measurable random variables X : Ω → Rm , normed 1

by XLp = EQ [ |X|p ] p ; L∞ the space of bounded random variables; • S p (Rm ) the space of all measurable processes (Yt )t∈[0,T ] with values in Rm 1

normed by Y S p = E[(supt∈[0,T ] |Yt |)p ] p ; S ∞ (Rm ) the space of bounded measurable processes; • H p (Rm , Q) the space of all progressively measurable processes (Zt )t∈[0,T ] with 1 T values in Rm normed by ZH p = EQ [( 0 |Zs |2 ds)p/2 ] p ; • BMO(F , Q) or BMO2 (F , Q) the space of square integrable F -martingales Φ with Φ0 = 0 and we set Φ2BMO(F ,Q) = sup EQ Φ T − Φ τ |Fτ < ∞, ∞

τ

where the supremum is taken over all stopping times τ ∈ [0, T ]. More details on this space can be found in Appendix 1. In case Q resp. F is clear from the context, we may omit the arguments Q or F and simply write BMO(Q) resp. BMO(F ) etc; • Dk,p (Rd ) and Lk,d (Rd ) the spaces of Malliavin differentiable random variables and processes, see Appendix 2. In case there is no ambiguity about m or Q, we may omit the reference to Rm or Q and simply write S ∞ or H p etc. We investigate systems of forward diffusions coupled with backward stochastic differential equations with quadratic growth in the control variable (qgFBSDE for short), i.e. given x ∈ Rm , t ∈ [0, T ], and four continuous measurable functions b, σ , g and f we analyze systems of the form t t b(s, Xsx )ds + σ (s, Xsx )dWs , (1) Xtx = x + 0

Ytx

= g(XTx ) +

t

0

T

f (s, Xsx , Ysx , Zsx )ds

− t

T

Zsx dWs .

(2)

In case there is no ambiguity about the initial state x of the forward system, we may and do suppress the superscript x and just write X, Y, Z for the solution components. For the coefficients of this system we make the following assumptions: (H0) There exists a positive constant K such that b, σi : [0, T ] × Rm → Rm , 1 ≤ i ≤ d, are uniformly Lipschitz continuous with Lipschitz constant K, and b(·, 0) and σi (·, 0), 1 ≤ i ≤ d, are bounded by K. There exists a constant M ∈ R+ such that g : Rm → R is absolutely bounded by M, f : [0, T ] × Rm × R × Rd → R is measurable and continuous in (x, y, z) and for (t, x) ∈ [0, T ] × Rm , y, y ∈ R and z, z ∈ Rd we have


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|f (t, x, y, z)| ≤ M(1 + |y| + |z|2 ), |f (t, x, y, z) − f (t, x, y , z )| ≤ M |y − y | + (1 + |z| + |z |)|z − z | . The theory of SDE is well established. Since we wish to focus on the backward equation component of our system we emphasize that the relevant results for SDE are summarized in Appendix 3. Theorem 1 (Properties of qgFBSDE) Under (H0), the system (1), (2) has a unique solution (X, Y, Z) ∈ S 2 × S ∞ × H 2 . The respective norms of Y and Z can be dominated from above by constants depending only on T and M as given by assumption (H0). Furthermore . Zs dWs ∈ BMO(P) and hence for all p ≥ 2 one has Z ∈ H p . Z∗W = 0

It is possible to go beyond the bounded terminal condition hypothesis by imposing the existence of all its exponential moments instead. In this case Z ∗ W is no longer in BMO. As we shall see in Sect. 4, the BMO property of Z ∗ W plays a crucial role in all of our smoothness results for systems of FBSDE. It combines with the inverse Hölder inequality for the exponentials generated by BMO martingales to control moments of functionals of the solutions of FBSDE. Smoothness of solutions is instrumental for instance in estimates for numerical approximations of solutions.

3 Pricing and Hedging with Correlated Assets The pivotal task of mathematical finance is to provide solid foundations for the valuation of contingent claims. In recent years, markets have displayed an increasing need for financial instruments pegged to non-tradable underlyings such as temperature and energy indices or toxic matter emission rates. In the same manner as liquidly traded underlyings, securities on non-tradable underlyings are used to measure, control and manage risks, as well as to speculate and take advantage of market imperfections. Since non-tradability produces residual risks which are innate and inaccessible to hedging, institutional investors look for tradable assets which are correlated to the non-tradable ones. In incomplete markets, one established pricing paradigm is the utility maximization principle. Upon choosing a risk preference, investors evaluate contingent claims by replicating according to an investment strategy that yields the most favorable utility value. Interplays and connections between the pricing of contingent claims on non-tradable underlyings and the theory of qgFBSDE were studied, among others, by [2, 12, 17], and recently by [10]. Based on this setup, we consider the problem of numerically evaluating contingent claims based on non-tradable underlyings. This will be done by intervention of the exponential transformation

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of qgBSDE, to be introduced in Sect. 6. It allows to work under weaker assumptions than the numerical schemes for qgFBSDE based on the results reviewed in Sect. 4, and will allow some illustrative numerical simulations in Sect. 7. The following toy market setup can be found in Sect. 4 of [10]. Assume d = 2, so that W = (W 1 , W 2 ) is our basic two-dimensional Brownian motion. We use them to define a third Brownian motion W 3 correlated to W 1 with respect to a correlation coefficient ρ ∈ [−1, 1] according to s s

3 1 Ws := ρdWu + 1 − ρ 2 dWu2 , 0 ≤ s ≤ T . 0

0

Contingent claims are assumed to be tied to a one-dimensional non-tradable index that is subject to dRt = μ(t, Rt )dt + σ (t, Rt )dWt1 ,

R0 = r0 > 0,

(3)

where μ, σ : [0, T ] × R → R are deterministic measurable and uniformly Lipschitz continuous functions, uniformly of (at most) linear growth in their state variable. The securities market is governed by a risk free bank account yielding zero interest and one correlated risky asset whose dynamics (with respect to the zero interest bank account numéraire) are governed by dSs = α(s, Rs )ds + β(s, Rs )dWs3 , Ss

S0 = s0 > 0.

(4)

In compliance with [2], we assume that α, β : [0, T ] × R → R are bounded and measurable functions, and furthermore β 2 (t, r) ≥ ε > 0 holds uniformly for some fixed ε > 0. Next, we set θ (s, r) :=

α(s, r) , β(s, r)

(s, r) ∈ [0, T ] × R,

and note that the conditions on α and β imply that θ is uniformly bounded. An admissible investment strategy is defined to be a real-valued, measurable preT dictable process λ such that 0 λ2u du < ∞ holds P-almost surely and such that the family τ dSu e−η 0 λu Su : τ stopping time with values in [0, T ] (5) is uniformly integrable. The set of all admissible investment strategies is denoted by A . In the following, let t ∈ [0, T ] denote a fixed time. Then the set of all admissible investment strategies living on the time interval [t, T ] is defined analogously and we denote it by At . Let vt denote the investor’s initial endowment at time t, that is, vt is an Ft -measurable bounded random variable. The gain of the investor at time s ∈ [t, T ], denoted by Gs , is subject to trading according to investing λ into the risky asset, and therefore given by dGλs = λs

dSs , Ss

Gλt = 0.


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We focus on European style contingent claims, i.e. payoff profiles resuming the form F (RT ) where we assume, in accordance with [2], that F : R → R is measurable and bounded. Moreover the investor’s risk assessment presumes that her utility preference is reflected by the exponential utility function, so given a nonzero constant risk attitude parameter η, the investor’s utility function is U (x) = −e−ηx ,

x ∈ R.

The evolution of the investor’s portfolio over the time interval [t, T ] consists of her initial endowment vt , her gains (or losses) via her investment into the risky asset under an investment strategy λ and holding one share of the contingent claim F (RT ). Her objective is to find an investment strategy such that her time-t utility is maximized, i.e. her maximization problem is given by

VtF (vt ) := sup E U (vt + GλT + F (RT )) Ft : λ ∈ At

= exp {−ηvt } sup E U (Gλ + F (RT )) Ft : λ ∈ At . (6) T

For the sake of notational convenience, we write

VtF := VtF (0) = sup E U (GλT + F (RT )) Ft : λ ∈ At .

(7)

Now pricing F (RT ) within the utility maximization paradigm is based on the identity Vt0 (vt ) = VtF (vt − pt ), where Vt0 (vt ) denotes the time-t utility with initial endowment vt and with F = 0 (see also Sect. 2 of [2] and Sect. 3 of [10]). According to this identity, the investor is indifferent about a portfolio with initial endowment vt without receiving one quantity of the contingent claim F (RT ) and a portfolio with initial endowment vt − pt , now receiving one quantity of the contingent claim in addition. Hence pt is interpreted as the time-t indifference price of the contingent claim F (RT ). By the equality VtF (vt ) = exp {−ηvt } VtF , it follows that pt =

V0 1 log tF , η Vt

(8)

which means that the indifference price does not depend on the initial endowment vt . Since the time-t indifference price (8) is fully characterized by Vt0 and VtF , the focus now lies in the investigation of (6). In fact, [2] and [10] have already pointed out that (7) yields a characterization by means of a qgFBSDE. In accordance with [10], let us denote by (Gu )0≤u≤T the filtration generated by W 1 , completed by Pnull sets. [10]’s main ideas for rephrasing (6) in terms of a qgBSDE are summarized in the following Lemma 1 The qgFBSDE Ys = F (RT ) +

T

s

f (u, r, z) =

f (u, Ru , Zu )du − s

T

Zu dWu1 ,

s ∈ [0, T ],

η θ 2 (u, r) − zρθ (u, r) − (1 − ρ 2 )z2 , 2η 2

(9) (10)

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has a unique solution (Y, Z) ∈ S ∞ × H 2 such that VtF = −e−ηYt holds P-almost surely. Proof Since θ (·, r) is uniformly bounded and G -predictable, the driver of (9) satisfies the conditions of [14]; thus (9) admits a unique solution (Y, Z) ∈ S ∞ × H 2 . Moreover, [16] have shown that Z ∗ W 1 is both a BMO(F )- and BMO(G )martingale. See also [2]. To prove the identity VtF = −e−ηYt , we notice that e−η

λ GT +YT

λ

= e−ηYt e because

Gλt

λ GT −Gλt −η(YT −Yt ) −η GλT −Gλt

= e−ηGt e−ηYt e−η(YT −Yt ) e−η e

,

= 0. We then have exp{−η(YT − Yt )} exp{−η(GλT − Gλt )} T T = exp −η Zu dWu1 + λu β(u, Ru )dWu3 +

t

T

t

[λu α(u, Ru ) − f (u, Ru , Zu )]du .

t

Denoting Ets (M) = E (M)s /E (M)t for t ≤ s ≤ T where E (M)s is the stochastic exponential of a given semi-martingale M, we introduce 2 1 Ku := η(ρZu + β(u, Ru )λu ) − θu , t ≤ u ≤ T . 2 Then a simple calculation yields exp{−η(YT − Yt )} exp{−η(GλT − Gλt )} T 1 3 = Et −ηZdW − ηλβ(·, R)dW exp

T

Ku du .

t

is a BMO-martingale, we can condition with respect to the Since λβ(·, R) ∗ σ -algebra Ft and get

λ (11) E e−η(GT +F (RT )) Ft ≥ e−ηYt . W3

By (5) and a localization argument, this inequality holds for every λ ∈ At , and therefore we have VtF ≤ −e−ηYt . To prove equality, note that the inequality (11) becomes ρ θ(u,Ru ) Zu + ηβ(u,R ; this in conjunction with the observation an equality for λ˜ u = − β(u,R u) u) that T ˜ dSu ˜ ˜ ˜ exp −η λu = exp −ηGλT = exp −η GλT − Gλt Su t T 1 3 ˜ = Et −ηZdW − ηλβ(·, R)dW × exp{η(YT − Yt )} is the product of a bounded process and true F -martingale yields that condition (5) is satisfied. Hence λ˜ ∈ At and we have shown VtF = −e−ηYt . The proof of the previous Lemma 1 yields the following


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Corollary 1 The investment strategy λ˜ s := −

ρ θ (s, Rs ) Zs + , β(s, Rs ) ηβ(s, Rs )

t ≤ s ≤ T,

(12)

where Z is the control component of the solution to (9), belongs to At and satisfies

˜ E U (vt + GλT + F (RT ) Ft = sup E U (vt + GλT + F (RT ) Ft : λ ∈ At = VtF (vt ). Example 1 [Put option on kerosene, compare with Example 1.2 from [2]] Facing recent considerable declines in world oil prices, companies producing kerosene wish to partially cover their risk of such a depreciation. European put options are an established financial instrument to comply with this demand of risk covering. Since kerosene is not traded in a liquid market, derivative contracts on this underlying must be arranged on an over-the-counter basis. Knowing that the price of heating oil is highly correlated with the price of kerosene, the pricing and hedging of a European put option on kerosene can be done by a dynamic investment in (the liquid market of) heating oil. A numerical treatment of this pricing problem will be displayed in Sect. 7.

4 Smoothness and Path Regularity Results The principal aim of this paper is to survey some recent results on the numerical approximation of prices and hedging strategies of financial derivatives such as the liability F (RT ) in the setting of the previous section. As we saw, this leads us directly to qgFBSDE. In the subsequent sections we shall discuss an approach based on a truncation of the driver’s quadratic part in the control variable. It will be crucial to give an estimate for the error committed by truncating. Our error estimate will be based on smoothness results for the control component Z x of solutions of the BSDE part of our system. Smoothness is understood both in the sense of regular sensitivity to initial states x of the forward component, as well as in the sense of the stochastic calculus of variations. Since the control component of the solution of a BSDE is related to the Malliavin trace of the other component, we will be led to look at variational derivatives of the first order. Our first result concerns the smoothness of the map [0, T ] × Rm (t, x) → Ztx , especially its differentiability in x. The second result refers to the variational differentiability of (Y x , Z x ) in the sense of Malliavin’s calculus. We shall work under the following hypothesis, where we denote the gradient by the common symbol ∇, and by ∇u if we wish to emphasize the variable u with respect to which the derivative is taken. (H1) Assume that (H0) holds. For any 0 ≤ t ≤ T the functions b(t, ·), σi (t, ·), 1 ≤ i ≤ d, are continuously differentiable with bounded derivatives in the spatial variable. There exists a positive constant c such that y T σ (t, x)σ T (t, x)y ≥ c|y|2 ,

x, y ∈ Rm , t ∈ [0, T ].

(13)

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f is continuously partially differentiable in (x, y, z) and there exists M ∈ R+ such that for (t, x, y, z) ∈ [0, T ] × Rm × R × Rd |∇x f (t, x, y, z)| ≤ M(1 + |y| + |z|2 ), |∇y f (t, x, y, z)| ≤ M, |∇z f (t, x, y, z)| ≤ M(1 + |z|). g : Rm → R is a continuously differentiable function satisfying |∇g| ≤ M.

4.1 Smoothness Results The following differentiability results are extensions of Theorems proved in [1] and [5]. For further details, comments and complete proofs we refer to the mentioned works or to [7]. Theorem 2 (Classical differentiability) Suppose that (H1) holds. Then for all p ≥ 2 the solution process Θ x = (X x , Y x , Z x ) of the qgFBSDE (1), (2) with initial vector x ∈ Rm for the forward component belongs to S p × S p × H p . The application Rm x → (X x , Y x , Z x ) ∈ S p (Rm ) × S p (R) × H p (Rd ) is differentiable. The derivatives of x → X x satisfy (21) while the derivatives of the map x → (Y x , Z x ) satisfy the linear BSDE T T ∇Zsx dWs + ∇f (s, Θsx ), ∇Θsx ds, t ∈ [0, T ]. ∇Ytx = ∇g(XTx )∇XTx − t

t

Theorem 3 (Malliavin differentiability) Suppose that (H1) holds. Then the solution process (X, Y, Z) of FBSDE (1), (2) has the following properties. For x ∈ Rm , • X x satisfies (22) and for any 0≤t ≤T , x ∈Rm we have (Y x , Z x )∈L1,2 ×(L1,2 )d . X x fulfills the statement of Theorem 11, and a version of (Du Ytx , Du Ztx )0≤u,t≤T satisfies Du Ytx = 0,

Du Ztx = 0, t < u ≤ T , T T Du Ytx = ∇g(XTx )Du XTx + ∇f (s, Θsx ), Du Θsx ds − Du Zsx dWs , t

t ∈ [u, T ].

t

Moreover, (Dt Ytx )0≤t≤T defined by the above equation is a version of (Ztx )0≤t≤T . • The following representation holds for any 0 ≤ u ≤ t ≤ T and x ∈ Rm Du Ytx = ∇x Ytx (∇x Xux )−1 σ (u, Xux ),

a.s.,

Zt = ∇x Ytx (∇x Xtx )−1 σ (s, Xtx ),

a.s..


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4.2 Regularity and Bounds for the Solution Process A careful analysis of DY in both its variables under the smoothness assumptions on the coefficients of our system formulated earlier reveals the following continuity properties for the control process Z. Theorem 4 (Time continuity and bounds) Assume (H1). Then the control process Z of the qgFBSDE (1), (2) has a continuous version on [0, T ]. Furthermore for all p ≥ 2 it satisfies ZS p < ∞.

(14)

Theorem 5 (Regularity) Under (H1) the solution process (X, Y, Z) of the qgFBSDE (1), (2) satisfies for all p ≥ 2 i) there exists a constant Cp > 0 such that for 0 ≤ s ≤ t ≤ T we have p E sup |Yu − Ys |p ≤ Cp |t − s| 2 ; s≤u≤t

ii) there exists a constant Cp > 0 such that for any partition π = {t0 , . . . , tN } with 0 = t0 < · · · < tN = T of [0, T ] with mesh size |π| p N −1 ti+1 2 p 2 E |Zt − Zti | dt ≤ Cp |π| 2 . i=0

ti

Now let h = T /N , π N = {ti = ih : i = 0, . . . , N} be an equidistant partition of [0, T ] with N + 1 points and constant mesh size h. Let Z be the control component in the solution of the qgFBSDE (1), (2) under (H1) and define the family of random variables

1 ti+1 N Z¯ tπi = E Zs ds Fti , ti ∈ π N \ {tN }. (15) h ti For 0 ≤ i ≤ N − 1 the random variable Z¯ tπi is the best Fti -measurable approximation of Z in H 2 ([ti , ti+1 ]), i.e. ti+1 ti+1 N |Zs − Z¯ tπi |2 ds = inf E |Zs − Λ|2 ds , E N

Λ

ti

ti

where Λ is allowed to vary in the space of all square integrable Fti -measurable ranN N dom variables. By constant interpolation we define Z¯ tπ = Z¯ tπi for t ∈ [ti , ti+1 [, N 0 ≤ i ≤ N − 1. It is easy to see that (Z¯ tπ )t∈[0,T ] converges to (Zt )t∈[0,T ] in H 2 [0, T ] as h vanishes. Since Z is adapted there exists a family of adapted N N processes Z π indexed by our equidistant partitions such that Ztπ = Zti for N N t ∈ [ti , ti+1 ) and that Z π converges to Z in H 2 as h tends to zero. Since Z¯ π 2 is the best H -approximation of Z, we obtain Z − Z¯ π H 2 ≤ Z − Z π H 2 → 0, N

N

as h → 0.

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The following Corollary of Theorem 5 extends Theorem 3.4.3 in [19] (see Theorem 12) to the setting of qgFBSDE. Corollary 2 (L2 -regularity of Z) Under (H1) and for the sequence of equidistant T , we have partitions (π N )N ∈N of [0, T ] with mesh size h = N max

sup

0≤i≤N −1 t∈[ti ,ti+1 )

−1 N E |Yt − Yti |2 + E i=0

ti

ti+1

N |Zs − Z¯ tπi |2 ds ≤ Ch,

where C is a positive constant independent of N . Remark 1 The above corollary still holds if (H1) is weakened. More precisely, the corollary’s statement remains valid if one replaces in (H1) the sentence “g : Rm → R is a continuously differentiable function satisfying |∇g| ≤ M.” by “g : Rm → R is uniformly Lipschitz continuous in all its variables.” The proof requires a regularization argument.

5 A Truncation Procedure To the best of our knowledge so far none of the usual discretization schemes for FBSDE has been shown to converge in the case of systems of FBSDE considered in this paper, the driver of which is of quadratic growth in the control variable. The regularity results derived in the preceding section have the potential to play a crucial role in numerical approximation schemes for qgFBSDE. We shall now give arguments to substantiate this claim. In fact, the regularity of the control component of the solution processes of our BSDE will lead to precise estimates for the error committed in truncating the quadratic growth part of the driver. We will next explain how this truncation is done in our setting. We start by introducing a sequence of real valued functions (h˜ n )n∈N that truncate the identity on the real line. For n ∈ N the map h˜ n is continuously differentiable and satisfies • h˜ n → id locally uniformly, |h˜ n | ≤ |id| and |h˜ n | ≤ n + 1; moreover ⎧ x > n + 2, ⎨ (n + 1), |x| ≤ n, h˜ n (x) = x, ⎩ −(n + 1), x < −(n + 2); • the derivative of h˜ n is absolutely bounded by 1 and converges to 1 locally uniformly.


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We remark that such a sequence of functions exists. The above requirements are for instance consistent with − n2 + 2nx − x(x − 4) /4, x ∈ [n, n + 2], h˜ n (x) = 2 n + 2nx + x(x + 4) /4, x ∈ [−(n + 2), −n]. We then define hn : Rd → Rd by z → hn (z) = (h˜ n (z1 ), . . . , h˜ n (zd )), n ∈ N. The sequence (hn )n∈N is chosen to be continuously differentiable because the properties stated in Theorem 4 need to hold for the solution processes of the family of FBSDE that the truncation sequence generates by modifying the driver according to the following definition. Recalling the driver f of BSDE (2), for n ∈ N we define fn (t, x, y, z) := f (t, x, y, hn (z)), (t, x, y, z) ∈ [0, T ] × Rm × R × Rd . With this driver and (1) we obtain a family of truncated BSDE by T T n n n Yt = g(XT ) + fn s, Xs , Ys , Zs ds − Zsn dWs , t ∈ [0, T ], n ∈ N. (16) t

t

The following Theorem proves that the truncation error leads to a polynomial deviation of the corresponding solution processes in their natural norms, formulated for polynomial order 12. Theorem 6 Assume that (H1) is satisfied. Fix n ∈ N and let X be the solution of (1). Let (Y, Z) and (Y n , Z n )n∈N be the solution pairs of (2) and (16) respectively. Then for all p ≥ 2 there exists a positive constant Cp such that for all n ∈ N T p 2 1 n p n 2 ≤ Cp 12 . E sup |Yt − Yt | + E |Zs − Zs | ds n 0 t∈[0,T ] The proof of Theorem 6 roughly involves estimating the probability that Z n exceeds the threshold n as a function of n ∈ N through Markov’s inequality. The application of Markov’s inequality is possible thanks to (14).

6 The Exponential Transformation Method In the preceding sections we exhibited the significance of path regularity for the solution of systems of qgFBSDE, in particular the control component, for their numerical approximation. In this section we shall discuss an alternative route to path regularity of solutions in a particular situation that allows for weaker conditions than in the preceding sections. We will use the exponential transform known in PDE theory as the Cole-Hopf transformation. This mapping takes the exponential of the component Y of a solution pair as the new first component of a solution pair of a modified BSDE. It makes a quadratic term in the control variable of the form z → γ |z|2 vanish in the driver of the new system. The price one has to pay for this

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approach is a possibly missing global Lipschitz condition in the variable y for the modified driver. It is therefore not clear if the new BSDE is amenable to the usual numerical discretization techniques. We give sufficient conditions for the transformed driver to satisfy a global Lipschitz condition. In this simpler setting our techniques allow an easier access to smoothness results for the solutions of the transformed BSDE. The Cole-Hopf transformation being one-to-one, it is clear that regularity results carry over to the original qgFBSDE. Under (H0), we consider the transformation P = eγ Y and Q = γ P Z. It transforms our qgBSDE (2) with driver f into the new BSDE T 1 |Q|2s log Ps Qs γ Ps f s, Xs , − ds , Pt = eγ g(XT ) + γ γ Ps 2 Ps t T − Qs dWs , t ∈ [0, T ]. (17) t

Combining (17) with SDE (1), we see that for any p ≥ 2 a unique solution (X, P , Q) ∈ S p × S ∞ × H p of (1) and (17) exists. The properties of this triple follow from the properties of the solution (X, Y, Z) of the original qgFBSDE (1) and (2). For clarity, we remark that since Y is bounded, P is also bounded and bounded away from 0. The latter property allows us to deduce from the BMO martingale property of Z ∗ W the BMO martingale property of Q ∗ W . For the rest of this section we denote by K a compact subset of (δ, +∞) for some constant δ ∈ R+ in which P takes its values. The form of the driver in (17) indicates that after transforming drivers of the form of the following hypothesis, we have good chances to deal with a Lipschitz continuous one. (H0*) Assume that (H0) holds. For γ ∈ R let f : [0, T ] × Rm × R × Rd → R be of the form γ f (t, x, y, z) = l(t, x, y) + a(t, z) + |z|2 , 2 where l and a are measurable, l is uniformly Lipschitz continuous in x and y, a is uniformly Lipschitz continuous and homogeneous in z, i.e. for c ∈ R, (s, z) ∈ [0, T ] × Rd we have a(s, cz) = ca(s, z); l and a continuous in t. Assumption (H0*) allows us to simplify the BSDE obtained from the exponential transformation to T T γ g(XT ) Pt = e + F (s, Xs , Ps , Qs )ds − Qs dWs , t ∈ [0, T ], (18) t

t

where the driver is defined by F : [0, T ] × Rm × K × Rd → R,

q log p + γp a s, . (s, x, p, q) → γp l s, x, γ γp

(19)


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Thanks to the homogeneity assumption on a our driver simplifies further. Indeed, we have for (s, x, p, q) ∈ [0, T ] × Rm × R × Rd log p + a(s, q). (20) F (s, x, p, q) = γp l s, x, γ The terminal condition of the transformed BSDE still keeps the properties it had in the original setting. Indeed, boundedness of g is inherited by exp(γ g). Furthermore, if g is uniformly Lipschitz, then clearly by boundedness of g, the function eγ g is uniformly Lipschitz as well. Let us next discuss the properties of the driver (19) in the transformed BSDE. We recall that since l and a are Lipschitz continuous, there is a constant C > 0 such that for all (s, x, p, q) ∈ [0, T ] × Rm × K × Rd we have

log p

+ a(s, q)

|F (s, x, p, q)| ≤ γp l s, x, γ ≤ C|p|(1 + |x| + | log p | + |q|) ≤ C(1 + |x| + |p| + |q|). This means that F is of linear growth in x, p and q. To verify Lipschitz continuity properties of F in its variables x, p and q, by (20) and the Lipschitz continuity assumptions on a, it remains to verify that log p (x, p) → γp l s, x, γ is Lipschitz continuous in x and p, with a Lipschitz constant independent of s ∈ [0, T ]. As for x, this is an immediate consequence of the Lipschitz continuity of l in x. For p we have to recall that p is restricted to a compact set K ⊂ R+ not containing 0, to be able to appeal to the Lipschitz continuity of l in y. This shows that F is globally Lipschitz continuous in its variables x, p and q. We may summarize these observations in the following Theorem. Theorem 7 Let f : [0, T ] × Rm × R × Rd → R be a measurable function, continuous on Rm × R × Rd , and satisfying (H0*). Then F as defined by (19) is a uniformly Lipschitz continuous function in the spatial variables. Theorem 7 opens another route to tackle convergence of numerical schemes via path regularity of the control component of a solution pair of a qgFBSDE system whose driver satisfies (H0*). Look at the new BSDE after applying the Cole-Hopf transform. Since it possesses a Lipschitz continuous driver, path regularity for the control component Q of the transformed BSDE will follow from Zhang’s path regularity result stated in (12) provided the driver is 12 -Hölder continuous in time. Of course, by the smoothness of the Cole-Hopf transform, the control component Z of the original BSDE will inherit path regularity from Q. This way we circumvent the more stringent assumption (H1) which was made in Sect. 4. In what follows the triples (X, Y, Z) and (X, P , Q) will always refer to the solution of qgFBSDE (1), (2) and FBSDE (1), (18) respectively.

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Theorem 8 Let (H0*) hold. Assume that [0, T ] × Rm × K × Rd (s, x, p, q) → F (s, x, p, q) ∈ R, the driver of BSDE (18), is uniformly Lipschitz in x, p and q and is 12 -Hölder continuous in s. Suppose further that the map g : Rd → R, as indicated in (H0), is globally Lipschitz continuous with Lipschitz constant K. Let (X, Y, Z) be the solution of qgFBSDE (1), (2), and ε > 0 be given. There exists a positive constant C such that for any partition π = {t0 , . . . , tN } with 0 = t0 , T = tN , t0 < · · · < tN of the interval [0, T ], with mesh size |π| we have max sup E |Yt − Yti |2 ≤ C|π| and 0≤i≤N −1

t∈[ti ,ti+1 )

N −1 i=0

E ti

ti+1

|Zs − Z¯ tπi |2 ds ≤ C|π|1−ε .

Moreover, if the functions b and σ are continuously differentiable in x ∈ Rm then t → Zt is a.s. continuous in [0, T ]. Proof Throughout this proof C will always denote a positive constant the value of which may change from line to line. Let (X, P , Q) be the solution of (1) and (18), where P takes its values in K and Q ∗ W is a BMO martingale. Applying Theorem 12 yields a positive constant C such that for any partition π = {t0 , . . . , tN } of [0, T ] with mesh size |π| max

sup

0≤i≤N −1 t∈[ti ,ti+1 )

−1 N E |Pt − Pti |2 + E i=0

ti+1 ti

¯ πt |2 ds ≤ C|π|. |Qs − Q i

Since P takes its values in the compact set K ⊂ R+ not containing 0 there exists a constant C such that for any 0 ≤ i ≤ N − 1, t ∈ [ti , ti+1 ) |Yt − Yti | = C| log Pt − log Pti | ≤ C|Pt − Pti |. Using the two above inequalities we have sup E |Yt − Yti |2 ≤ C max sup max

0≤i≤N −1

t∈[ti ,ti+1 )

0≤i≤N −1 t∈[ti ,ti+1 )

E |Pt − Pti |2 ≤ C|π|.

This proves the first inequality. For the second one, note that by definition for 0 ≤ i ≤ N − 1, t ∈ [ti , ti+1 )

1

Qt Qt

Qt Qti

+ |Zt − Z¯ ti | ≤ |Zt − Zti | ≤ − − γ Pt Pti Pti Pti

1 1 1 1

≤ + |Qt | − |Qt − Qti | γ Pt Pti |Pti | ≤ C{|Qt | |Pt − Pti | + |Qt − Qti |}.


We therefore have for 0 ≤ i ≤ N − 1 ti+1 π 2 ¯ |Zs − Zti | ds ≤ E E ti

ti+1

ti

175

|Zs − Zti | ds

≤ 2C E sup

2

|Pt − Pti |2

+E ti

|Qs |2 ds

ti

t∈[ti ,ti+1 )

ti+1

ti+1 2 |Qt − Qti | ds .

Since Q ∈ H for all p ≥ 2, for any two real numbers α, β ∈ (1, ∞) satisfying 1/α + 1/β = 1 we may continue using Hölder’s inequality on the right hand side of the inequality just obtained, and then Theorem 12 to the term containing P . This yields the following inequality valid for any 0 ≤ i ≤ N − 1 with a constant C not depending on i p

E ti

1 α |Zs − Z¯ tπi |2 ds ≤ C E sup |Pt − Pti |2α E

ti+1

t∈[ti ,ti+1 )

β 1 β |Qs |2 ds +|π|

ti+1

ti

1 1 α ≤ C E sup |Pt − Pti |2 + |π| ≤ C{|π| α + |π|}. t∈[ti ,ti+1 ) 1 , to complete the claimed estimate. Now choose α = 1−ε To prove that Z admits a.s. a continuous version, it is enough to remark that the Theorem’s assumptions imply the conditions of Corollary 5.6 in [15]. The referred result yields that Q is a.s. continuous on [0, T ]. Since P is continuous and bounded away from zero we conclude from the equation γ P Z = Q that Z is a.s. continuous as well.

7 Back to the Pricing Problem We now come back to the numerical valuation of the put option on kerosene as depicted in Example 1. Notations in the following are adopted from Sect. 3. Assume that the put option expires at T = 1. Let R and S denote the dynamics for the financial value of kerosene and heating oil respectively. In particular we assume both dynamics to be lognormally distributed according to dRt = μ(t, Rt )dt + σ (t, Rt )dWt1 = 0.12 Rt dt + 0.41 Rt dWt1 , dSt = α(t, Rt )dt + β(t, Rt )dWt3 = 0.1 dt + 0.35 dWt3 , St and we assume the spot price for heating oil to be s0 = 173 money units (e.g. US Dollar, Euro), see also equations (3) and (4). Risk aversion is set at the level of

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Fig. 1 Price paths of the nontradable asset kerosene and the correlated asset heating oil at different correlation levels. The spot of kerosene was set to r0 = 170

η = 0.3. Figure 1 displays sample paths of the kerosene price with a spot price of r0 = 170 and heating oil price at different correlation levels using the explicit solution formula for the geometric Brownian motion. We see that the higher the correlation, the better the approximation of the kerosene by heating oil becomes. We have seen that the valuation of the put option via utility maximization yields the pricing formula (8) which in conjunction with Lemma 1 becomes the difference of two solutions of a qgBSDE with the generator (10) pt = YtF − Yt0 ,

0 ≤ t ≤ T,

where F (x) = (K − x)+ for some strike K > 0. For the numerical simulation of the qgFBSDE Y F and Y 0 , we apply the exponential transformation to both BSDE (see Sect. 6) and then employ the algorithm by [3] with N = 100 equidistant time points, 70000 paths and a regression basis consisting of five monomials and the payoff function of the put option. The Picard iteration stops as soon as the difference of two subsequent time zero values is less than 10−5 . Simulations reveal that 12 to 13 iterations are needed for solving one exponentially transformed qgFBSDE. Figures 2(a) and 2(b) depict the time zero price p0 of the put option at different strike and kerosene spot levels. The lower the correlation, the lower the price becomes. This is clear because lower correlations between heating oil and kerosene lead to higher non-hedgeable residual risk which diminishes the risk covering effect of the contingent claim and thus also its value. Figures 3(a) and 3(b) depict sample paths of the dynamics for the price pt and the optimal investment strategy πt for an at the money put with strike K = 180 and kerosene spot r0 = 170. The plots depict price and monetary investment for every fourth time point of the discretization. The


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(a) Put option price in terms varying strikes at a fixed kerosene spot r0 = 170

(b) Put option price in terms of varying kerosene spots at a fixed strike K = 200 Fig. 2 Values of the put option in terms of kerosene spot and strike for varying correlations. High correlations lead to high the prices for the contingent claim

price process and the dynamics of the optimal investment strategy are intertwined: high fluctuations of the price process result in high fluctuations of the investment strategy and vice versa. In general we observe that replication on high correlation levels tends to entail greater market activity because kerosene price risks can then be

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(a) Dynamics of the price process pt for strike K = 180

(b) Dynamics of the optimal investment strategy πt for strike K = 180 Fig. 3 Paths of the price pt and the optimal investment strategy πt for varying correlation levels. In general high correlations entail greater market activity

well hedged by market transactions that move closely along the dynamics of heating oil. In contrast, replication on lower correlation levels leads to a higher amount of residual risk which is inaccessible for hedging and thus lower market activity is needed.


179

Acknowledgements Gonçalo Dos Reis would like to thank both Romuald Elie and Emmanuel Gobet for the helpful discussions. Jianing Zhang acknowledges financial support by IRTG 1339 SMCP.

Appendix 1: Some Results on BMO Martingales BMO martingales play a key role for a priori estimates needed in our sensitivity analysis of solutions of BSDE. For details about this theory we refer the reader to [13]. Let Φ be a BMO(F , Q) martingale with Φ0 = 0. Φ being square integrable, the martingale t representation theorem yields a square integrable process φ such that Φt = 0 φs dWs , t ∈ [0, T ]. Hence the BMO(F , Q) norm of Φ can be alternatively expressed as T sup EQ φs2 ds|Fτ < ∞. τ F -stopping time in [0,T ]

τ

Lemma 2 (Properties of BMO martingales) Let Φ be a BMO martingale. Then we have: 1) The stochastic exponential E (Φ) is uniformly integrable. 2) There exists a number r > 1 such that E (ΦT ) ∈ Lr . This property follows from the Reverse Hölder inequality. The maximal r with this property can be expressedexplicitly in terms of the BMO norm of Φ. · 3) If Φ = 0 φs ds has BMO norm C, then for p ≥ 1 the following estimate holds p T ≤ 2p!(4C 2 )p . |φs |2 ds E 0

Hence BMO ⊂ H

p

for all p ≥ 1.

Appendix 2: Basics of Malliavin’s Calculus We briefly introduce the main notation of the stochastic calculus of variations also known as Malliavin’s calculus. For more details, we refer the reader to [18]. Let S be the space of random variables of the form T T 1 d,i d ξ =F h1,i dW , . . . , h dW , s s s s 0

where F ∈ Cb∞ (Rn×d ), tion, assume that all hj

1≤i≤n

0

j =1

L2 ([0, T ]; Rd ),

1≤i≤n

∈ n ∈ N. To simplify notaare written as row vectors. For ξ ∈ S , we define D = (D 1 , . . . , D d ) : S → L2 (Ω × [0, T ])d by T T n ∂F i,j h1t dWt , . . . , hnt dWt hθ , 0 ≤ θ ≤ T , 1 ≤ i ≤ d, Dθi ξ = ∂xi,j 0 0 h1 , . . . , hn

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and for k ∈ N its k-fold iteration by D (k) = (D i1 . . . D ik )1≤i1 ,...,ik ≤d . For k ∈ N, p ≥ 1 let Dk,p be the closure of S with respect to the norm k p p p (k) |D ξ |(H p )i . ξ k,p = E ξ Lp + i=1

D (k) is a closed linear operator on the space Dk,p . Observe that if ξ ∈ D1,2 is Ft measurable then Dθ ξ = 0 for θ ∈ (t, T ]. Further denote Dk,∞ = ∩p>1 Dk,p . We also need Malliavin’s calculus for smooth stochastic processes with values in Rm . For k ∈ N, p ≥ 1, denote by Lk,p (Rm ) the set of Rm -valued progressively measurable processes u = (u1 , . . . , um ) on [0, T ] × Ω such that i) For Lebesgue-a.a. t ∈ [0, T ], u(t, ·) ∈ (Dk,p )m ; ii) [0, T ] × Ω (t, ω) → D (k) u(t, ω) ∈ (L2 ([0, T ]1+k ))d×n admits a progressively measurable version; p p p iii) uk,p = uH p + ki=1 D i u (H p )1+i < ∞. Note that Jensen’s inequality gives for all p ≥ 2 p T T 2 2 p/2−1 ≤T |Du Xt | du dt E 0

0

0

T

p

Du XH p du.

Appendix 3: Some Results on SDE We recall results on SDE known from the literature that are relevant for this work. We state our assumptions in the multidimensional setting. However, for ease of notation we present some formulas in the one dimensional case. Theorem 9 (Moment estimates for SDE) Assume that (H0) holds. Then (1) has a unique solution X ∈ S 2 and the following moment estimates hold: for any p ≥ 2 there exists a constant C > 0, depending only on T , K and p such that for any x ∈ Rm , s, t ∈ [0, T ] T p p p p (|b(t, 0)| + |σ (t, 0)| )dt , E sup |Xt | ≤ CE |x| + 0≤t≤T

0

E sup |Xu − Xs |p ≤ CE |x|p + sup {|b(t, 0)|p + |σ (t, 0)|p } |t − s|p/2 .

s≤u≤t

0≤t≤T

Furthermore, given two different initial conditions x, x ∈ Rm , we have E sup |Xtx − Xtx |p ≤ C|x − x |p . 0≤t≤T


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Theorem 10 (Classical differentiability) Assume (H1) holds. Then the solution process X of (1) as a function of the initial condition x ∈ Rm is differentiable and satisfies for t ∈ [0, T ] t t ∇b(Xs )∇Xs ds + ∇σ (Xs )∇Xs dWs , (21) ∇Xt = Im + 0

0

where Im denotes the m × m unit matrix. Moreover, ∇Xt as an m × m-matrix is invertible for any t ∈ [0, T ]. Its inverse (∇Xt )−1 satisfies an SDE and for any p ≥ 2 there are positive constants Cp and cp such that ∇XS p + (∇X)−1 S p ≤ Cp and

E sup |(∇Xu ) − (∇Xs )|p + sup |(∇Xu )−1 − (∇Xs )−1 |p ≤ cp |t − s|p/2 . s≤u≤t

s≤u≤t

Theorem 11 (Malliavin Differentiability) Under (H1), X ∈ L1,2 and its Malliavin derivative admits a version (u, t) → Du Xt satisfying for 0 ≤ u ≤ t ≤ T the SDE t t Du Xt = σ (Xu ) + ∇b(Xs )Du Xs ds + ∇σ (Xs )Du Xs dWs . (22) u

u

Moreover, for any p ≥ 2 there is a constant Cp > 0 such that for x ∈ Rm and 0 ≤ v≤u≤t ≤s≤T p

Du XS p ≤ Cp (1 + |x|p ), p

E[ |Du Xt − Du Xs |p ] ≤ Cp (1 + |x|p )|t − s| 2 , p

p

Du X − Dv XS p ≤ Cp (1 + |x|p )|u − v| 2 . By Theorem 10, we have the representation Du Xt = ∇Xt (∇Xu )−1 σ (Xu )1[0,u] (t),

for all u, t ∈ [0, T ].

Appendix 4: Path Regularity for Lipschitz FBSDE We state a version of the L2 -regularity result for FBSDE satisfying a global Lipschitz condition. The result which was seen to be closely related to the convergence of numerical schemes for systems of FBSDE is due to [19]. For our FBSDE system (1), (2) we assume that b, σ, f, g are deterministic measurable functions that are Lipschitz continuous with respect to the spatial variables and 12 -Hölder continuous with respect to time. Furthermore we assume that σ satisfies (13). Then from [8] one easily obtains existence and uniqueness of a solution triple (X, Y, Z) of FBSDE (1), (2) belonging to S 2 × S 2 × H 2 . For a partition π of [0, T ] define the process Z¯ π as in (15). Then the following result holds.

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Theorem 12 (Path regularity result of [19]) Let (X, Y, Z) ∈ S 2 × S 2 × H 2 be the solution of FBSDE (1), (2) in the setting described above. Then there exists C ∈ R+ such that for any partition π = {t0 , . . . , tN } of the time interval [0, T ] with mesh size |π| we have sup E |Yt − Yti |2 max 0≤i≤N −1 t∈[ti ,ti+1 )

+

N −1 i=0

E ti

ti+1

N −1 π 2 ¯ |Zs − Zti | ds + E i=0

ti

ti+1

|Zs − Zti | ds ≤ C|π|. 2

References 1. Ankirchner, S., Imkeller, P., dos Reis, G.: Classical and variational differentiability of BSDEs with quadratic growth. Electron. J. Probab. 12(53), 1418–1453 (2007) 2. Ankirchner, S., Imkeller, P., dos Reis, G.: Pricing and hedging of derivatives based on nontradable underlyings. Math. Finance 20(2), 289–312 (2010) 3. Bender, C., Denk, R.: A forward simulation of backward SDEs. Stochastic Process. Appl. 117(12), 1793–1812 (2007) 4. Bouchard, B., Touzi, N.: Discrete-time approximation and Monte-Carlo simulation of backward stochastic differential equations. Stochastic Process. Appl. 111(2), 175–206 (2004) 5. Briand, P., Confortola, F.: BSDEs with stochastic Lipschitz condition and quadratic PDEs in Hilbert spaces. Stochastic Process. Appl. 118(5), 818–838 (2008) 6. Delarue, F., Menozzi, S.: A forward-backward stochastic algorithm for quasi-linear PDEs. Ann. Appl. Probab. 16(1), 140–184 (2006) 7. dos Reis, G.: On some properties of solutions of quadratic growth BSDE and applications in finance and insurance. PhD thesis, Humboldt University (2009) 8. El Karoui, N., Peng, S., Quenez, M.C.: Backward stochastic differential equations in finance. Math. Finance 7(1), 1–71 (1997) 9. Elie, R.: Contrôle stochastique et méthodes numériques en finance mathématique. PhD thesis, Université Paris-Dauphine (2006) 10. Frei, C.: 2009 Convergence results for the indifference value in a Brownian setting with variable correlation. Preprint, available at www.cmapx.polytechnique.fr/~frei 11. Gobet, E., Lemor, J.P., Warin, X.: A regression-based Monte Carlo method to solve backward stochastic differential equations. Ann. Appl. Probab. 15(3), 2172–2202 (2005) 12. Imkeller, P., Réveillac, A., Richter, A.: Differentiability of quadratic BSDE generated by continuous martingales and hedging in incomplete markets. arXiv:0907.0941v1 (2009) 13. Kazamaki, N.: Continuous Exponential Martingales and BMO. Lecture Notes in Mathematics, vol. 1579, p. 91. Springer, Berlin (1994) 14. Kobylanski, M.: Backward stochastic differential equations and partial differential equations with quadratic growth. Ann. Probab. 28(2), 558–602 (2000) 15. Ma, J., Zhang, J.: Path regularity for solutions of backward stochastic differential equations. Probab. Theory Relat. Fields 122(2), 163–190 (2002) 16. Mania, M., Schweizer, M.: Dynamic exponential utility indifference valuation. Ann. Appl. Probab. 15(3), 2113–2143 (2005) 17. Morlais, M.A.: Quadratic BSDEs driven by a continuous martingale and applications to the utility maximization problem. Finance Stoch. 13(1), 121–150 (2009) 18. Nualart, D.: The Malliavin Calculus and Related Topics, 2nd edn. Probability and its Applications (New York), p. 382. Springer, Berlin (2006) 19. Zhang, J.: Some fine properties of BSDE. PhD thesis, Purdue University (2001)

Variance Swap Portfolio Theory Dilip B. Madan

Abstract Optimal portfolios of variance swaps are constructed taking account of both autocorrelation and cross asset dependencies. Market prices of variance swaps are extracted from option surface calibrations. The methods developed permit simulation of cash flows to arbitrary portfolios of variance swaps. The optimal design maximizes the index of acceptability introduced in (Cherny and Madan, Review of Financial Studies, 2009). Full nonlinear optimization is contrasted with Simultaneous Perturbation Stochastic Approximation (SPSA). Preliminary out of sample results favor the use of SPSA.

1 Introduction Financial markets now allow one to invest directly in the realized variances of stocks over a prespecified interval time. A natural question that arises is the construction or design of optimal portfolios of realized variance. This is the analog of the classical portfolio theory for stock investment, beginning with [5], except we now hold portfolios of realized variance and seek an optimal position. Our approach to this question is broadly similar to the traditional analysis offered by [5], requiring one to describe the distributional properties of various portfolios with the selected portfolio being one that optimizes a criterion measuring the quality of the distribution accessed. The context of trading variance swaps or realized squared returns over a prespecified future period, however, introduces a variety of complexities in the task of describing the distribution of cash flows accessed by potential portfolios. The first among these is the recognition that squared returns are highly autocorrelated and are subject to considerable levels of clustering. Consequently one must account for such autocorrelations in describing future outcomes. Additionally, volatility movements are also correlated across assets and have distributions could D.B. Madan () Robert H. Smith School of Business, University of Maryland, College Park, MD 20742, USA e-mail: [email protected] C. Chiarella, A. Novikov (eds.), Contemporary Quantitative Finance, DOI 10.1007/978-3-642-03479-4_10, © Springer-Verlag Berlin Heidelberg 2010

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possess both skewness and excess kurtosis. The design of optimal portfolios should therefore reflect these aspects of the problem and a simulation of potential portfolio cash flows should preferably employ non-Gaussian yet correlated outcomes across assets and time, coupled with optimization criteria that are sensitive to skewness. The issues to be addressed are therefore somewhat more involved than those faced in studying stock portfolios. Ultimately we wish to be able to simulate the joint evolution of squared log returns on a number of stocks for a fixed number of days representing the maturity of the variance swap contracts to be traded. One may then take long and short positions in these cash flows to generate the outcomes for a candidate portfolio of variance swaps. In the process we need to ensure that the simulated squared returns remain positive. We begin by directly modeling time series data for daily squared log returns. To account for autocorrelation in these data series it is natural to consider a regression model for daily squared log returns with their lagged values as explanatory variables. However, it is difficult to keep a linear regression model positive in a forward simulation. One could run then run the regressions in the logarithm of daily squared log returns, but placing a probability model on the residuals of such a transformation makes returns a double exponential and one is likely to end up with very unreasonable return outcomes. With a view to overcoming this difficulty we consider transformations other than the exponential that map the real line to the positive half line but have a linear rather than exponential behaviour for large arguments. We call this transformation a Hardy-Littlewood Gauss transform as it is based on using a Gaussian density in a transformation suggested by Hardy and Littlewood. The regression is run on data obtained by applying the inverse Hardy Littlewood Gauss transform to daily squared log returns. After accounting for autocorrelation we model the marginal distributions of regression residuals, expecting them to display both some skewness and excess kurtosis. A simple and fairly robust distribution with these properties is given by the variance gamma, VG model. For the modeling of dependence we follow [4] and use the marginal distributions to transform the residuals to Gaussian random variates that we then correlate. Our model for the residuals is then a nonlinear transform of correlated multivariate normals. We may then simulate forward the regression model and obtain candidate observations on squared log returns by applying the Hardy Littlewood Gauss transform to the output of the simulated regression. These cash flows may be averaged and annualized to get the floating or random leg of the individual variance swaps. The price of the variance swap as estimated from a calibration of the individual option surface yields the fixed leg of the variance swap and subtracting this value from the floating leg one obtains readings on individual variance swap outcomes. Portfolio cash flows can then be easily constructed and it remains to describe the criterion for selection of the optimal portfolio. For this purpose we follow recent advances in performance measurement introduced in [2] and maximize an index of acceptability. Such indices are infinite for arbitrages and hence if there is a sample space arbitrage the optimization of such a criterion will find the arbitrage. Like the Sharpe ratio or Gain Loss ratio, the criterion is scale invariant and the search for

Variance Swap Portfolio Theory

185

the portfolio design may be restricted to the compact set defined by the unit sphere. We employ the suggested criterion of maximizing the MINMAXVAR acceptability index as this criterion is particularly sensitive towards the avoidance of large losses, and is in this regard conservative. In constructing the optimal portfolio one is optimizing on a simulated space of outcomes and a nonlinear optimizer may overly leverage aspects of the sample space that are not relevant to real out of sample performance. For this reason we employ both a general nonlinear optimizer and stochastic approximation using simultaneous perturbation for gradient estimation to economize on function evaluations in high dimensions. The complete portfolio design strategy is illustrated on a sample of the top 50 stocks of the Standard and Poor Index along with a position in the index variance. We report on trading one month variance swaps at nonoverlapping one month intervals. The model is estimated, simulated, and the optimal portfolio is constructed at each month end using prior data on an adaptive basis. Sample empirical results for each section are summarized in that section. A final section reports on the actual out of sample performance of each portfolio constructed at month end. The outline of the rest of the paper is as follows. Section 1 describes the autocorrelation strategy and the use of the Hardy Littlewood Gauss transform. The joint law for the regression residuals are formulated in Sect. 2. Section 3 presents the model used to price the fixed leg of the variance swap contracts. Section 4 presents the optimization criterion, the problem constraints, and the two optimization methods employed. Results are provided in Sect. 5 and Sect. 6 concludes.

2 Autocorrelation and the Hardy Littlewood Gauss Transform We take data on the prices of the top 50 stocks on the S&P500 index as at November 11 2008 along with the time series of the index as well. Let Si,t denote the price of asset i at market close on day t for i = 1, . . . , 51 with asset 51 being the index level. The daily realized variance for asset i on day t is defined by 2 Si,t vi,t = ln Si,t−1 and the cash flow on a one month variance swap entered into on day t is given on day t + 21 by t+21 252 2 vi,n − ki,t Notional × 21 n=t+1

where ki,t is the variance swap quote for asset i at market close on day t and is an annualized volatility. An analysis of variance swap portfolios requires a simultaneous generation of daily squared log returns for the coming months on all 51 assets. As noted in the introduction, squared log returns are highly autocorrelated and the simulation of a linear model estimated on data for vi,t will not stay positive in the

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forecast period. We therefore wish to transform the data on vi,t from the positive half line to the real line and a popular transformation with this property is the logarithm. However, if we model vi,t as an exponential then returns are a double exponential and this introduces unreasonable return outcomes for any reasonable probability model placed on the logarithm of vi,t . We therefore consider other transformations from the real line to the positive half line that do not grow as fast as an exponential. There are a wide class of such transformations g(x) that behave linearly for positive and large x values. Let f (x) be any symmetric density on the real line with f (−x) = f (x) and finite expectation of |x|. A candidate for the transformation g(x) is given by ∞ uf (u)du g(x) = x ∞ . (1) x f (u)du The function g is easily seen to be positive, and tending to 0 as x tends to negative infinity, while for large x, g(x) behaves like x. We refer to (1) as a Hardy Littlewood transform and we shall use the Hardy Littlewood Gauss transform when we take f (x) to be the standard normal density. Applying the inverse of the Hardy Littlewood Gauss transform to data on vi,t we generate real valued data xi,t = g −1 (vi,t ). We account for autocorrelation in squared returns by employing a linear model on the data xi,t . In our specific application we take account of five lags and estimate the linear model xi,t = ai +

5

bj xi,t−j + ui,t .

j =1

The linear model was estimated on six months of daily data prior to the date of portfolio construction. Forecasts of xi,t may be transformed to positive forecasts of squared daily log returns on applying the Hardy Littlewood Gauss transform to these forecasts.

3 NonGaussian Dependence Model In addition to autocorrelation, we need to account for the possibility of skewness, excess kurtosis and correlation across assets. We observe that the residuals from the autocorrelation regressions do possess significant levels of skewness and excess kurtosis and it would be risky to overly understate extreme outcomes in modeling squared return cash flow outcomes. With these considerations in mind we estimate the variance gamma model on standardized residuals by maximum likelihood. This model can capture nonzero departures in skewness and excess kurtosis in standardized data. Given that we have non Gaussian marginal distributions for our regression residuals, it is not helpful to merely correlate these residuals as one has no joint


187

probability law associated with these correlation computations from which one may draw on possible candidate outcomes. Here we follow [4] and transform our standardized residuals to standard Gaussian variates by using the estimated VG distribution functions to obtain zit = N −1 FiV G (ui,t ) where N(x) is the standard normal distribution function. We then correlate the data on zit to get a residual correlation matrix C. One may then simulate outcomes from a multivariate Gaussian with correlation C to construct non Gaussian correlated residuals by ui,t,s = (FiV G )−1 (N (zi,t,s )). These residuals are fed into the regression model to generate xi,t,s a candidate occurrence for asset i at time t on paths s. Applying the Hardy Littlewood Gauss transform provides outcomes vi,t,s . We employed 10000 paths and generated 21 forward squared returns on each of 51 assets after estimating 51 variance gamma models on the residuals ui,t of a regression run on six months of historical data. The floating leg of the variance swap contract for unit notional can then be constructed on each of 10000 paths as Vis =

t+21 252 vi,n,s . 21 n=t+1

The cash flow requires the construction of the fixed leg on each asset. This is accomplished in the next section.

4 Variance Swap Fixed Leg Pricing For each of the 51 assets, the 50 stocks and the S&P 500 index, on each portfolio construction date, we have to obtain the price of the variance swap contract for the maturity of the variance contract being considered. For this purpose we extract prices of out-of-the-money options in the maturity range of one month to one year and follow [1] to summarize this surface using the four parameters of the Sato process based on the VG and termed VGSSD in [1]. Once this model is estimated on the option surface one has an analytical expression for the risk distribution of the logarithm stock at each maturity. The price of the variance swap contract may be estimated by computing the expectation of the log price relative treated as a futures price process by employing a zero interest rate and dividend yield. Specifically let

φM (u, t) = E Q exp (iu ln(M(t))) where the stock price process S(t) for an interest rate of r and a dividend yield q is given by S(t) = S(0)e(r−q)t M(t).

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The characteristic function for M(t) is easily extracted from that for S(t). The price of the variance swap contract, k, is then computed by ∂φM (u, t) |u=0 . k 2 t = 2i ∂u For each portfolio construction date we estimated the VGSSD model for all 51 underliers and then transformed the parameters into a variance swap price. We have tested this procedure applied to SPX options with one month variance swap quotes then being compared with the VIX index. The correlation over a 300 day period was 99.26 and one does not reject the hypothesis of a zero intercept and a unit slope on regressing one against the other. This value is denoted ki,t and the simulated cash flow to asset i on the variance swap on path s is then obtained as 2 . ci,s = Vi,s − ki,t

The matrix of cash flows to potential swaps is 51 by 10000 and can be generated on each portfolio design date using this procedure.

5 Optimization Criterion and Portfolio Design We now consider the formation of portfolios taking positions a = (ai , i = 1, . . . , 51) in the variance swap on asset i. The magnitude ai is a dollar notional amount that may be positive or negative depending on whether the swap is purchased or sold, with the portfolio cash flow cs (a) on path s being cs (a) =

51

ai cis .

i=1

The portfolio design strategy is to choose a with a view to optimizing the random variable being accessed. Traditional design criteria include Sharpe ratios, expected utility, RAROC, the gain loss ratio among other possibilities. We note that all these performance measurement criteria are just functions of the probability law of the random variable being accessed. Recently, [2] reviewed these criteria for measuring performance and axiomatized and defined indices of acceptability for random cash flows that range from zero for a positive expectation to infinity for an arbitrage. The indices, like other performance measures are scale invariant. The indices that depend solely on the probability law are easily constructed as the highest level of stress such that a stressed expectation is positive at this level. Stressed expectations are expectations under a concave distortion of the distribution function that effectively exaggerates losses and simultaneously discounts gains, much like marginal utility, though unlike a specific utility the reweighting is further exaggerated as one raises the stress level. The criterion delivers a convex set of acceptable risks at each level of acceptability and tractable examples of such indices include MINVAR where the stress amounts to computing the expectation of the minimum of a number of independent draws. It is noted that large losses are not heavily discounted in MINVAR and the proposed criterion is MINMAXVAR that uses the distortion Ψ γ at level γ of 1

Ψ γ (u) = 1 − (1 − u 1+γ )1+γ ,

0 ≤ u ≤ 1.


189

We choose our portfolio of variance swaps to maximize the level of acceptability of the cash flow being accessed. This criterion has been employed in portfolio allocation across stocks by [3]. The computation of the distorted expectation amounts to evaluating ∞ cdΨ γ (F (c)) −∞

for a cash flow with distribution function F (c). When a cash flow is sampled by simulation one estimates the distorted expectation by sorting the cash flows in increasing order c1 < c2 < · · · < cN and evaluating the sum N n n−1 −Ψγ . cn Ψ γ N N n=1

The index is given by the largest level of γ for which the distorted expectation is positive and it is clear that this is infinity if there are no negative outcomes and one has a sample space arbitrage or a real arbitrage. Given that the objective is scale invariant one may restrict the portfolio design search to the unit sphere by requiring that 51

ai2 = 1.

(2)

i=1

We are interested in designing a relative variance trade that goes buys the more volatile and sells the less volatile and so we take an aggregate portfolio that is zero dollar. This constrains the portfolio to satisfy 51

2 ki,t ai = 0.

(3)

i=1

Additionally we avoid an aggregate volatility risk with a zero vega constraint by requiring 51

ki,t ai = 0.

(4)

i=1

We therefore design the portfolio to maximize the index of acceptability subject to the constraints (2), (3), and (4). The optimization may be accomplished on a fixed sample space, or one may regenerate the sample space and treat the problem as one with a stochastic objective. The regeneration is quite expensive and we maximized the criterion on a fixed sample space. A full nonlinear optimization may however unduly leverage the sample space and one may consider instead a stochastic approximation algorithm. Given the dimension of 51 the gradient computation in such an algorithm is expensive and so we coupled stochastic approximation with simultaneous perturbation to get a gradient estimate in just two function evaluations (see [6]). We present results for both algorithms and report on both the in sample and out of sample performance.

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D.B. Madan

Table 1 Robust regression results Ticker

Constant

Lag 1

Lag 2

Lag 3

Lag 4

Lag 5

xom

−2.7045

−0.0122

0.0449

0.0647

0.0928

0.1192

ge

−1.7717

0.0771

0.0110

0.0551

0.1496

0.2501

msft

−2.6504

0.2050

−0.0059

0.0307

0.0587

0.0308

jpm

−2.5522

0.1024

0.0489

0.0200

0.1089

0.0038

bac

−1.6697

0.1135

0.1250

0.1089

0.1140

0.0474

aapl

−2.3872

−0.0151

0.1460

0.1363

0.1135

−0.0191 0.0697

goog

−2.3593

0.0975

0.1255

−0.0556

0.1487

c

−2.1977

0.1395

0.1332

−0.0750

0.1280

0.0463

mmm

−2.5363

0.0553

−0.0053

0.0219

0.1715

0.1293

spx

−1.9689

0.0314

0.0890

0.0818

0.1448

0.1687

We find that the full nonlinear optimization of the index of acceptability does find sample space arbitrages with the zero dollar and zero vega constraints imposed. In this case we also maximize the minimum cash flow on the sample space.

6 Results on Portfolio Design Portfolios were formulated once a month in 2008 for 9 months ranging from February through October. The exact design dates were February 27, March 27, April 25, May 26, June 24, July 23, August 21, September 19, and October 20. We shall summarize the back test results of all nine positionings but describe in detail the components for just the last portfolio for October 20. We present results for a subset of the 50 companies and the SPX. The first step was the robust regression performed on the inverse Hardy Littlewood Gauss transform of daily squared log returns with five lags and a constant run on six months of prior data. The coefficient matrix for the subset is presented in Table 1. We observe that the constant term for the SPX is lower indicative of a lower overall volatility. The lagged coefficients are mainly positive with a substantial relative size at lag five for four of the ten names listed. The second step is the estimation of marginal laws for the residuals of the regression. This was done on standardized data for the residuals with generated samples being destandardized using the sample means and standard deviations. The probability model used was the variance gamma. We report the parameter estimates for the selected 10 names in Table 2. We observe significant levels of excess kurtosis and negative skewness indicating that residual densities are skewed down relative to the regression forecast. This is particularly the case for the SPX. We next use the marginal distributions to transform the residual data to a standard Gaussian density that we then correlate. The eigenvalues of the correlation matrix are reported in Table 3.

Variance Swap Portfolio Theory Table 2 VG estimates for standardized residuals

Table 3 Top 25 eigenvalues of correlation matrix in decreasing order

191 Ticker

σ

ν

θ

xom

0.6491

1.2013

−0.2003

ge

0.5139

0.4502

−0.7925

msft

0.4593

0.7754

−0.5303

jpm

0.6269

0.7561

−0.3358

bac

0.7387

1.0487

−0.2548

aapl

0.6173

1.6938

−0.1939

goog

0.5239

0.6704

−0.3807

c

0.6148

0.8940

−0.5860

mmm

0.5278

0.8309

−0.3996

spx

0.0794

0.3201

−1.2305

22.2209

2.9558

2.0834

1.5779

1.3561

1.1752

1.1204

1.0572

1.0271

0.9435

0.9092

0.8961

0.7928

0.7532

0.7460

0.7048

0.6626

0.6148

0.5842

0.5702

0.5178

0.5051

0.4914

0.4654

0.4371

Table 4 Selected residual correlations xom

ge

msft

jpm

bac

aapl

goog

c

mmm

xom

1

0.4734 0.4361 0.3369 0.3106 0.4033 0.3278 0.2686 0.4563 0.5165

ge

0.4734 1

msft

0.4361 0.3821 1

jpm

0.3369 0.5097 0.3910 1

0.3821 0.5097 0.4662 0.5495 0.4011 0.5454 0.6269 0.6990 0.3910 0.3252 0.5290 0.6485 0.3809 0.4588 0.5729 0.7459 0.4795 0.4303 0.7082 0.4901 0.5695

bac

0.3106 0.4662 0.3252 0.7459 1

aapl

0.4033 0.5495 0.5290 0.4795 0.4537 1

goog

0.3278 0.4011 0.6485 0.4303 0.3859 0.5408 1

c

0.2686 0.5454 0.3809 0.7082 0.7124 0.5324 0.4379 1

0.4537 0.3859 0.7124 0.5328 0.5680 0.5408 0.5324 0.4862 0.5748 0.4379 0.4869 0.6172 0.4876 0.5694

mmm 0.4563 0.6269 0.4588 0.4901 0.5328 0.4862 0.4869 0.4876 1 spx

spx

0.7070

0.5165 0.6990 0.5729 0.5695 0.5680 0.5748 0.6172 0.5694 0.7070 1

The smallest eigenvalue was 0.0643. The correlations between the ten selected names are provided in Table 4. We observe that the financial stocks are more correlated with each other that with other assets as are the technology stocks. We may now simulate correlated Gaussians from the estimated correlation matrix, then transform them to dependent marginals that are fed into updating the regression equations whose output is transformed by the Hardy Littlewood Gauss

192

D.B. Madan

Table 5 VGSSD parameters on 20081020 Ticker

σ

ν

θ

γ

RMSE

APE

MOP

xom

0.3879

1.2669

−0.3690

0.4099

0.1959

0.0376

52

ge

0.5399

0.9931

−0.4632

0.5422

0.0961

0.0460

28

msft

0.4566

1.6828

−0.3560

0.4038

0.0505

0.0214

35

jpm

0.5517

0.9707

−0.6450

0.5258

0.1196

0.0288

64

bac

0.5991

0.8029

−0.8299

0.5103

0.0605

0.0187

43

aapl

0.5733

0.3933

−0.7815

0.4249

0.2355

0.0265

105

goog

0.4057

0.3503

−0.6342

0.4422

1.0779

0.0423

260

c

0.7001

0.9206

−0.8064

0.4643

0.0683

0.0272

26

mmm

0.3481

0.5172

−0.3573

0.3505

0.1052

0.0243

26

spx

0.2736

0.8210

−0.3529

0.4141

1.1356

0.0211

194

Table 6 One month variance swaps on 20081020 xom

ge

msft

jpm

bac

aapl

goog

c

mmm

spx

0.6675

0.6101

0.7611

0.7387

0.8696

0.8710

0.6192

1.0479

0.6075

0.5087

transform to a reading on daily squared returns for each of the 51 underliers. To get to the cash flow we need to get the price of the individual variance swap contracts and this is done by calibrating the VGSSD Sato process to the option surface of each underlier and we report the results of this calibration for our selected underliers in Table 5. We used our method of pricing the log contract analytically to derive the prices of the one month variance swap contract and for the selected underliers on 20081020 these are provided in Table 6. We may now construct simulated cash flows to one month variance swaps for all 51 underliers to generate a matrix of size 51 by 10000 that gives the cash flow to each underlier for each of 10000 simulated scenarios. This matrix may be used to construct portfolio cash flows given by a simulated vector of 10000 readings for each portfolio. An optimizer is then employed to construct an optimal portfolio that maximizes the level of acceptability (AI) of the cash flow using the stress function MINMAXVAR. We also maximized the minimum outcome (MN) and found that this was positive yielding a sample space arbitrage even after imposing a zero dollar zero vega constraint. In addition we employed SPSA to generate optimal portfolios. We present the positions for the selected assets using all three methods in Table 7. We now report on the results of holding the optimal portfolio as constructed by AI, MN, or SPSA for the following month and recording the actual resulting cash flow. These one month forward realized results are presented in Table 8. We see that the June positions lost money as did March. The August and September trades were very profitable. It appears that SPSA performed the best though this

Variance Swap Portfolio Theory Table 7 Sample positions for the three strategies

193 Ticker

MN

SPSA

xom

0.2890

0.0867

−0.0198

ge

0.0609

0.0989

0.0114

msft

−0.2665

−0.1816

−0.2117

jpm

0.2493

0.3573

−0.0247

bac

0.3010

0.0687

0.1278

aapl

−0.0268

−0.0200

−0.0754

0.0935

0.1932

0.1015

goog c

Table 8 Realized results one month forward

AI

0.0604

0.1446

0.0317

mmm

−0.1653

−0.2522

0.0977

spx

−0.0845

−0.1556

0.2104

Design Date

AI

MN

SPSA

20080227

0.1383

0.1383

0.1990

20080327

−0.0893

−0.0716

−0.0842

20080425

−0.0051

−0.0032

0.0167

20080526

0.0701

0.0552

0.0746

20080624

−0.2342

−0.1122

−0.2850

20080723

0.0888

0.0527

0.1120

20080821

0.2108

0.1771

0.3917

20080919

0.4327

0.4180

0.5294

Total

0.6122

0.6544

0.9542

is not a full optimization and therefore it does not excessively leverage the particular path space. From an out of sample perspective this may be a strong point of this procedure, noting that performs better than the full optimization alternatives in six of the eight months. A more extensive study of this issue is called for.

7 Conclusion We develop procedures for constructing optimal portfolios of variance swaps. This requires a specification of the joint law of squared returns accounting for both autocorrelation and cross asset dependencies. We account for autocorrelation using a linear model on transformed variates focused on maintaining the positivity of squared returns in a subsequent simulation. Cross asset dependence is modeled by a copula approach, specifically by applying a multivariate normal model on marginal transformed to Gaussian variates. Market prices of variance swaps are extracted from option surface calibrations. The methods allow for a simulation of cash flows to

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D.B. Madan

portfolios of variance swaps. The portfolio design maximizes the arbitrage consistent recently introduced (see [2]) index of acceptability of random cash flows. Full nonlinear optimizers are contrasted with SPSA (Simultaneous Perturbation Stochastic Approximation) algorithms. Preliminary evidence suggests the possible potential superiority of SPSA, but further investigations are called for. The portfolio design program is illustrated on the top 50 stocks of the S&P 500 index as at November 11 2008. Positions were developed for each month of 2008 from February through October. The positions were generally profitable with losses occurring in June and March.

References 1. Carr, P., Geman, H., Madan, D., Yor, M.: Self decomposability and option pricing. Math. Finance 17, 31–57 (2007) 2. Cherny, A., Madan, D.B.: New measures of performance evaluation. Rev. Financ. Stud. Forthcoming, published on line (2009) 3. Eberlein, E., Madan, D.B.: Maximally acceptable portfolios. Working paper, University of Maryland (2009) 4. Malvergne, Y., Sornette, D.: Testing the Gaussian copula hypothesis for financial asset dependencies. Quant. Finance 3, 231–250 (2003) 5. Markowitz, H.: Portfolio selection. J. Finance 7, 77–91 (1952) 6. Spall, J.: Multivariate stochastic approximation using a simultaneous perturbation gradient approximation. IEEE Trans. Autom. Control 37, 332–341 (1992)

Stochastic Partial Differential Equations and Portfolio Choice Marek Musiela and Thaleia Zariphopoulou

Abstract We introduce a stochastic partial differential equation which describes the evolution of the investment performance process in portfolio choice models. The equation is derived for two formulations of the investment problem, namely, the traditional one (based on maximal expected utility of terminal wealth) and the recently developed forward formulation. The novel element in the forward case is the volatility process which is up to the investor to choose. We provide various examples for both cases and discuss the differences and similarities between the different forms of the equation as well as the associated solutions and optimal processes.

1 Introduction We introduce a stochastic partial differential equation (SPDE) arising in optimal portfolio selection problems which describes the evolution of the value function process. The SPDE is expected to hold under mild conditions on the asset price dynamics and in general incomplete markets. The aim herein is not to study questions on the existence, uniqueness and regularity of the solution of the investment performance SPDE. These questions are very challenging due to the possible degeneracy and full nonlinearity of the equation as

M. Musiela BNP Paribas, 10 Harewood Avenue, London NW1 6AA, UK e-mail: [email protected] T. Zariphopoulou Oxford-Man Institute and Mathematical Institute, University of Oxford, 2 Walton Well Road, Oxford OX2 6ED, UK T. Zariphopoulou () Departments of Mathematics and IROM, McCombs School of Business, The University of Texas at Austin, 1 University Station, C1200, Austin, TX 78712, USA e-mail: [email protected] C. Chiarella, A. Novikov (eds.), Contemporary Quantitative Finance, DOI 10.1007/978-3-642-03479-4_11, © Springer-Verlag Berlin Heidelberg 2010

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well as other difficulties stemming from the market incompleteness. They require extensive study and effort and are being currently investigated by the authors and others. We stress that similar questions have not yet been established even for the simplest possible extension of the classical Merton model in incomplete markets, namely, a single factor model with Markovian dynamics (see [44]). Abstracting from technical considerations, we provide various representative examples with explicit solutions to the SPDE for two different formulations of the optimal investment problem. The first problem is the classical one in which one maximizes the expected utility of terminal wealth. This problem has been extensively analyzed either in its primal formulation via the associated Hamilton-JacobiBellman (HJB) equation in Markovian models or in its dual formulation. However, once one departs from the complete market setting very little, if anything, can be said about the properties of the maximal expected utility, especially with regards to its regularity, the optimal policies and related verification results. The investment performance SPDE offers an alternative way to examine the evolution of this process beyond the class of Markovian models. One might think of it as the non-Markovian analogue of the HJB equation. Besides providing information for the maximal expected investment performance, it also provides the optimal investment strategy in a generalized stochastic feedback form. Analyzing the SPDE could perhaps lead to a better understanding of the nature and properties of the value function as well as the optimal wealth and optimal investment processes. The second problem for which we provide the associated SPDE arises in an alternative approach for portfolio choice that is based on the so-called forward investment performance criterion. In this approach, developed by the authors during the last years, the investor does not choose her risk preferences at a single point in time but has the flexibility to revise them dynamically. Recall that in the classical problem once the trading horizon is chosen the investor not only can he not revise his preferences but he cannot extend his utility beyond the initially chosen horizon either. For the new problem, the SPDE plays a very important role, for it exposes in a very transparent way how this flexibility is being modeled. Indeed, this is done via the volatility component of the forward performance process. This input is up to the investor to choose. It represents his uncertainty about the upcoming changes – from one trading period to the next – of the shape of his current risk preferences. As expected, the SPDEs in the traditional and the forward formulations have similar structure (see (12) and (28)). However, there are fundamental differences. In the first case, a terminal condition is imposed (see (13)) which is in most cases deterministic. In other words, the solution is progressively measurable with regards to the market filtration in [0, T ) but degenerates to a deterministic function at the end of the horizon. In contrast, in the second formulation an initial condition is imposed and the solution does not degenerate at any future time. Moreover, as we will discuss later on, in the classical utility problem the investor’s volatility is uniquely determined while in the forward case it is not. A common characteristic of the traditional and forward SPDEs is the form of the drift. Their drifts are uniquely determined once the volatility and the market inputs are specified. One could say that there is similarity between the investment performance SPDEs and the ones appearing in term structure models.

Stochastic Partial Differential Equationsand Portfolio Choice

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The paper is organized as follows. In Sect. 2 we describe the investment model. In Sect. 3 we recall the classical maximal expected utility problem and derive the associated SPDE. In Sect. 4, we provide examples from models with Markovian dynamics driven by stochastic factors. We also examine the power and logarithmic cases. In Sect. 5, we recall the forward portfolio choice problem and, in analogy to the classical case, we derive the associated SPDE. We finish the section by discussing the connection between the forward investment problem and the traditional expected utility maximization one. In Sect. 6 we provide several examples. We start with the zero volatility case. We then examine two families of non-zero volatility models. The first family incorporates non-zero performance volatilities that model different market views and investment in terms of a benchmark (or different numeraire choice) while the second family corresponds to the forward analogue of the stochastic factor Markovian model.

2 The Investment Model The market environment consists of one riskless and k risky securities. The risky securities are stocks and their prices are modeled as Itô processes. Namely, for i = 1, . . . , k, the price Sti , t ≥ 0, of the ith risky asset satisfies d ji j i i i σt dWt , dSt = St μt dt + (1) j =1

with S0i > 0, for i = 1, . . . , k. The process Wt = (Wt1 , . . . , Wtd ), t ≥ 0, is a standard d-dimensional Brownian motion, defined on a filtered probability space (Ω, F , P). For simplicity, it is assumed that the underlying filtration, Ft , coincides with the one generated by the Brownian motion, that is Ft = σ (Ws : 0 ≤ s ≤ t). The coefficients μit and σti = (σt1i , . . . , σtdi ), i = 1, . . . , k, t ≥ 0, are Ft progressively measurable processes with values in R and Rd , respectively. For ji brevity, we use σt to denote the volatility matrix, i.e. the d × k random matrix (σt ), whose ith column represents the volatility σti of the ith risky asset. Alternatively, we write (1) as dSti = Sti (μit dt + σti · dWt ). The riskless asset, the savings account, has the price process Bt , t ≥ 0, satisfying dBt = rt Bt dt

(2)

with B0 = 1, and for a nonnegative, Ft -progressively measurable interest rate process rt . Also, we denote by μt the k × 1 vector with the coordinates μit and by 1 the k-dimensional vector with every component equal to one. The market coefficients, μt , σt and rt , are taken to be bounded (by a deterministic constant). We assume that the volatility vectors are such that μt − rt 1 ∈Lin(σtT ),

198


where Lin(σtT ) denotes the linear space generated by the columns of σtT . This implies that σtT (σtT )+ (μt − rt 1) = μt − rt 1 and, therefore, the vector λt = (σtT )+ (μt − rt 1)

(3) (σtT )+

is a solution to the equation = μt − rt 1. The matrix Penrose pseudo-inverse of the matrix σtT . It easily follows that σtT x

is the Moore-

σt σt+ λt = λt

(4)

and, hence, λt ∈ Lin(σt ). We assume throughout that the process λt is bounded by a deterministic constant c > 0, i.e., for all t ≥ 0, |λt | ≤ c. Starting at t = 0 with an initial endowment x ∈ R+ , the investor invests at any time t > 0 in the risky and riskless assets. The present value of the amounts invested are denoted, respectively, by πt0 and πti , i = 1, . . . , k. The present value of her aggregate investment is, then, given by Xtπ = ki=0 πti , t > 0. We will refer to X π as the discounted wealth generated by the (discounted) strategy (πt0 , πt1 , . . . , πtk ). The investment strategies will play the role of control processes. Their admissibility set is defined as A = π : πt is self-financing and Ft -progressively measurable t

with E |σs πs |2 ds < ∞ and Xtπ ≥ 0, t ≥ 0 . (5) 0

Using (1) and (2) we deduce that the discounted wealth satisfies, for t > 0, k t k t Xtπ = x + πsi (μis − rs )ds + πsi σsi · dWs . i=1 0

i=1 0

Writing the above in vector notation and using (3) and (4) yields dXtπ = πt · (μt − rt 1)dt + σt πt · dWt = σt πt · (λt dt + dWt ), where the (column) vector,

πt = (πti ; i

(6)

= 1, . . . , k).

3 The Backward Formulation of the Portfolio Choice Problem and the Associated SPDE The traditional criterion for optimal portfolio choice has been based on maximal expected utility (see the seminal paper [31]). The key ingredients are the choices of the trading horizon [0, T ] and the investor’s utility, uT : R+ → R at terminal time T . The utility function reflects the risk attitude of the investor at time T and is an increasing and concave function of his wealth. The objective is to maximize the expected utility of terminal wealth over admissible strategies. We will denote the set of such strategies by AT , a straightforward restriction of A on [0, T ]. The maximal expected utility is defined as V (x, t; T ) = sup EP (uT (XTπ )|Ft , Xt = x), AT

(7)


199

for (x, t) ∈ R+ × [0, T ]. The function uT satisfies the standard Inada condition (see, for example, [26] and [27]). We introduce the T -notation throughout this section to highlight the dependence of all quantities on the investment horizon at which the investor’s risk preferences are chosen. As solution of a stochastic optimization problem, V (x, t; T ) is expected to satisfy the Dynamic Programming Principle (DPP), namely, V (x, t; T ) = sup EP (V (Xsπ , s; T )|Ft , Xt = x), AT

(8)

for t ≤ s ≤ T . This is a fundamental result in optimal control and has been proved for a wide class of optimization problems. For a detailed discussion on the validity (and strongest forms) of the DPP in problems with controlled diffusions, we refer the reader to [14] and [42] (see, also, [5, 10, 29]). Key issues are the measurability and continuity of the value function process as well as the compactness of the set of admissible controls. It is worth mentioning that a proof specific to the problem at hand has not been produced to date.1 Besides its technical challenges, the DPP exhibits two important properties of the solution. Specifically, V (Xtπ , t; T ), is a supermartingale for an arbitrary investment strategy and becomes a martingale at an optimum (provided certain integrability conditions hold). Observe also that the DPP yields a backward in time algorithm for the computation of the maximal utility, starting at expiration with uT and using the martingality property to compute the solution at earlier times. For this, we refer to this formulation of the optimal portfolio choice problem as backward. Regularity results for the process V (x, t; T ) have not been produced to date except for special cases. To the best of our knowledge, the most general result for arbitrary utilities can be found in [28]. We continue with the derivation of the SPDE for the value function process. For the moment, the discussion is informal, for general regularity results are lacking. To this end, let us assume that V (x, t; T ) admits the Itô decomposition dV (x, t; T ) = b(x, t; T )dt + a(x, t; T ) · dWt

(9)

for some coefficients b(x, t; T ) and a(x, t; T ) which are Ft -progressively measurable processes. Let us also assume that the mapping x → V (x, t; T ) is strictly concave and increasing and that V (x, t; T ) is smooth enough so that the Itô-Ventzell formula can be applied to V (Xtπ , t; T ) for any strategy π ∈ AT . We then obtain dV (Xtπ , t; T ) = b(Xtπ , t; T )dt + a(Xtπ , t; T ) · dWt + Vx (Xtπ , t; T )dXtπ 1 + Vxx (Xtπ , t; T )dX π t + ax (Xtπ , t; T ) · dW, X π t 2 = (b(Xtπ , t; T ) + σt πt · (Vx (Xtπ , t; T )λt + ax (Xtπ , t; T )))dt 1 Recently, a weak version of the DPP was proposed in [6] where conditions related to measurable selection and boundness of controls are relaxed.

200


1 + Vxx (Xtπ , t; T )|σt πt |2 dt + (a(Xtπ , t; T ) + Vx (Xtπ , t; T )σt πt ) · dWt 2 = b(Xtπ , t; T ) + σt πt · σt σt+ (Vx (Xtπ , t; T )λt + ax (Xtπ , t; T )) 1 + Vxx (Xtπ , t; T )|σt πt |2 dt + (a(Xtπ , t) + Vx (Xtπ , t; T )σt πt ) · dWt . 2 From the DPP we know that the process V (Xtπ , t; T ) is a supermartingale for arbitrary admissible policies and becomes a martingale at an optimum. Let us now choose as control policy the process πt∗ = πt∗ (Xt∗ , t; T ) where the feedback process in the right hand side (denoted by a slight abuse of notation by πt∗ (x, t; T )) is given by πt∗ (x, t; T ) = −σt+

Vx (x, t; T )λt + σt σt+ ax (x, t; T ) , Vxx (x, t; T )

(10)

where Xt∗ is the wealth process generated by (6) with πt∗ being used. It is assumed that πt∗ ∈ AT . It is easy to check that πt∗ is the point at which the quadratic expression appearing in the drift above achieves its maximum and, moreover, that the maximum value at this point is given by 1 Vxx (Xt∗ , t; T )|σt πt∗ |2 + σt πt∗ · σt σt+ (Vx (Xt∗ , t; T )λt + ax (Xt∗ , t)) 2 1 |Vx (Xt∗ , t; T )λt + σt σt+ ax (Xt∗ , t; T )|2 . =− 2 Vxx (Xt∗ , t; T ) We, then, deduce that the drift coefficient b(x, t; T ) must satisfy b(x, t; T ) =

1 |Vx (x, t; T )λt + σt σt+ ax (x, t; T )|2 . 2 Vxx (x, t; T )

(11)

Combining the above leads to the SPDE dV (x, t; T ) =

1 |Vx (x, t; T )λt + σt σt+ ax (x, t; T )|2 dt + a(x, t; T ) · dWt (12) 2 Vxx (x, t; T )

with V (x, T ; T ) = uT (x).

(13)

To the best of our knowledge, the above SPDE has not been derived to date. For deterministic terminal utilities, the volatility a(x, t; T ) is present because of the stochasticity of the investment opportunity set, as the examples in the next section show. The optimal feedback portfolio process πt∗ consists of two terms, namely, πt∗,m = −

Vx (x, t; T ) + σ λt Vxx (x, t; T ) t

and πt∗,h = −σt+

ax (x, t; T ) . Vxx (x, t; T )


201

The first component, πt∗,m , known as the myopic investment strategy, resembles the investment policy followed by an investor in markets in which the investment opportunity set remains constant through time. The second term, πt∗,h , is called the excess hedging demand and represents the additional (positive or negative) investment generated by the volatility a(x, t; T ) of the performance process V .

4 Examples: Markovian Stochastic Factor Models Stochastic factors have been used in portfolio choice to model asset predictability and stochastic volatility. The predictability of stock returns was first discussed in [12, 13, 15] (see also [1, 7, 41] and others). The role of stochastic volatility in investment decisions was first studied in [2, 15, 16, 19] (see also [8, 23, 30] and others). There is a vast literature on such models and we refer the reader to the review paper [44] for detailed bibliography, exposition of existing results and open problems.

4.1 Single Stochastic Factor Models There is only one risky asset whose price St , t ≥ 0, is modeled as a diffusion process solving dSt = μ(Yt )St dt + σ (Yt )St dWt1 , with S0 > 0. The stochastic factor Yt , t ≥ 0, satisfies

dYt = b(Yt )dt + d(Yt ) ρdWt1 + 1 − ρ 2 dWt2 ,

(14)

(15)

with Y0 = y, y ∈ R. It is assumed that ρ ∈ (−1, 1). The market coefficients f = μ, σ, b and d satisfy the standard global Lipschitz and linear growth conditions |f (y) − f (y)| ¯ ≤ K|y − y| ¯ and f 2 (y) ≤ K(1 + y 2 ), for y, y¯ ∈ R. Moreover, it is assumed that the non-degeneracy condition σ (y) ≥ l > 0, y ∈ R, holds. It is also assumed that the riskless asset (cf. (2)) offers constant interest rate r > 0. The coefficients appearing in (12) take the form T 1 μ(Yt ) − r ,0 and λt = , 0 . (16) σt+ = σt = (σ (Yt ), 0)T , σ (Yt ) σ (Yt ) We easily see that condition (4) is trivially satisfied. The value function is defined as v(x, y, t; T ) = sup EP (uT (XT )|Xt = x, Yt = y), AT

for (x, y, t) ∈ R+ × R × [0, T ] and AT being the set of admissible strategies.

(17)

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Regularity results for the value function (17) for general utility functions have not been obtained to date except for the special cases of homothetic preferences (see, for example, [25, 32, 39, 43]). We, thus, proceed with an informal discussion for the associated HJB equation, the form of the process V and the optimal policies. To this end, the HJB turns out to be 1 2 2 vt + max σ (y)π vxx + π(μ(y)vx + ρσ (y)d(y)vxy ) π 2 1 (18) + d 2 (y)vyy + b(y)vy = 0, 2 with v(x, y, T ; T ) = uT (x), (x, y, t) ∈ R+ × R × [0, T ]. Its solution yields the process V , namely, for 0 ≤ t ≤ T , V (x, t; T ) = v (x, Yt , t; T ) .

(19)

We next show that V (x, t; T ) above solves the SPDE (12) with volatility vector a(x, t; T ) = (a1 (x, t; T ), a2 (x, t; T )) with a1 (x, t; T ) = ρd(Yt )vy

and a2 (x, t; T ) =

1 − ρ 2 d(Yt )vy ,

(20)

where the arguments of vy have been suppressed for convenience. Indeed, using (19), (16), (20) and Itô’s formula yields dV (x, t; T ) 1 = vt (x, Yt , t; T ) + d(Yt )2 vyy (x, Yt , t; T ) + b(Yt )vy (x, Yt , t; T ) dt 2

+ ρd(Yt )vy (x, Yt , t; T ), 1 − ρ 2 d(Yt )vy (x, Yt , t; T ) · dWt 1 1 = − max σ 2 (Yt )π 2 vxx (x, Yt , t; T ) 2 π 2 + π(μ(Yt )vx (x, Yt , t; T ) + ρσ (Yt )d(Yt )vxy (x, Yt , t; T )) dt

+ ρd(Yt )vy (x, Yt , t; T ), 1 − ρ 2 d(Yt )vy (x, Yt , t; T ) · dWt =

=

1 (μ(Yt )vx (x, Yt , t; T ) + ρσ (Yt )d(Yt )vxy (x, Yt , t; T ))2 dt 2 vxx (x, Yt , t; T )

+ ρd(Yt )vy (x, Yt , t; T ), 1 − ρ 2 d(Yt )vy (x, Yt , t; T ) · dWt 1 |Vx (x, t; T )λt + σt σt+ ax (x, t)|2 dt + a(x, t; T ) · dWt . 2 Vxx (x, t; T )

The optimal feedback portfolio process for t ≤ s ≤ T is obtained from (10). We easily deduce that it coincides with the feedback policy (evaluated at Ys ) derived from the first order conditions in the HJB equation. Indeed, for t ≤ s ≤ T ,


203

Vx (x, s; T )λs + σs σs+ ax (x, s; T ) Vxx (x, s; T ) λ(Ys ) vx (x, Ys , s; T ) d(Ys ) vxy (x, Ys , s; T ) =− −ρ σ (Ys ) vxx (x, Ys , s; T ) σ (Ys ) vxx (x, Ys , s; T ) = π ∗ (x, Ys , s; T )

πs∗ (x, s; T ) = −σs+

(21)

where π ∗ : R+ × R × [0, T ] is given by 1 2 ∗ 2 π (x, y, s; T ) = arg max σ (y)π vxx + π(μ(y)vx + ρσ (y)d(y)vxy ) . π 2 Next, we present two cases for which the above results are rigorous. Specifically, we provide examples for the most frequently used utilities, the power and the logarithmic ones. These utilities have convenient homogeneity properties which, in combination with the linearity of the wealth dynamics in the control policies, enable us to reduce the HJB equation to a quasilinear one. Under a “distortion” transformation (see, for example, [43]) the latter can be linearized and solutions in closed form can be produced using the Feynman-Kac formula. The smoothness of the value function and, in turn, the verification of the optimal feedback policies follows (see, among others, [23–25, 30, 43]).

4.1.1 The CRRA Case: uT (x) = γ1 x γ , 0 < γ < 1, γ = 0 The value function v (cf. (17)) is multiplicatively separable and given, for (x, y, t) ∈ R+ × R × [0, T ], by v(x, y, t; T ) =

1 γ x f (y, t; T )δ , γ

δ=

1−γ , 1 − γ + ρ2γ

(22)

where f : R × [0, T ] → R+ solves the linear parabolic equation 1 γ λ(y)d(y) fy ft + d 2 (y)fyy + b(y) + ρ 2 1−γ +

λ2 (y) γ f = 0, 2(1 − γ ) δ

(23)

with f (x, y, T ; T ) = 1. The value function process V (x, t; T ) is given by V (x, t; T ) =

1 γ x f (Yt , t; T )δ , γ

with f solving (23) and δ as in (22). Direct calculations show that it satisfies the SPDE (12) with volatility components (cf. (20)) ⎧ δ γ δ−1 ⎪ ⎪ ⎨ a1 (x, t; T ) = ρ γ x d(Yt )fy (Yt , t; T )f (Yt , t; T ) , (24) δ ⎪ ⎪ ⎩ a2 (x, t; T ) = 1 − ρ 2 x γ d(Yt )fy (Yt , t; T )f (Yt , t; T )δ−1 . γ

204


The optimal feedback portfolio process is given for t ≤ s ≤ T by (10), namely, Vx (x, s; T )λs + σs σs+ ax (x, s; T ) πs∗ (x, s; T ) = −σs+ Vxx (x, s; T ) fy (Ys , s; T ) λ(Ys ) d(Ys ) = +ρ x, σ (Ys )(1 − γ ) σ (Ys )(1 − γ + ρ 2 γ ) f (Ys , s; T ) which is in accordance with (21) and (22). 4.1.2 The Logarithmic Case: uT (x) = ln x, x > 0 The value function is additively separable, namely, v(x, y, t; T ) = ln x + h(y, t; T ), with h : R × [0, T ] → R+ solving 1 1 ht + d 2 (y)hyy + b(y)hy + λ2 (y)h = 0 (25) 2 2 and h(y, T ; T ) = 1. The value function process V (x, t; T ) is, in turn, given by V (x, t; T ) = ln x + h(Yt , t; T ). We easily deduce that it satisfies the SPDE (12) with volatility vector a1 (x, t; T ) = ρhy (Yt , t; T ) and a2 (x, t; T ) = 1 − ρ 2 hy (Yt , t; T ). Observe that because the volatility process does not depend on wealth, the excess risky demand is zero, as (10) indicates. Indeed, the optimal portfolio process is ∗ s) always myopic, given, for t ≤ s ≤ T , by πs∗ = σλ(Y (Ys ) Xs with s s 1 2 ∗ 1 λ (Yu )du + Xs = x exp λ(Yu )dWu . t 2 t The logarithmic utility plays a special role in portfolio choice. The optimal portfolio is known as the “growth optimal portfolio” and has been extensively studied in general market settings (see, for example, [3] and [21]). The associated optimal wealth is the so-called “numeraire portfolio.” It has also been extensively studied, for it is the numeraire with regards to which all wealth processes are supermartingales under the historical measure (see, among others, [17] and [18]).

4.2 Multi-stochastic Factor Models Multi-stochastic factor models for homothetic preferences have been analyzed by various authors. The theory of BSDE has been successfully used to characterize and represent the solutions of the reduced HJB equation (see [11]). The regularity of its solutions has been studied using PDE arguments in [32] and [39], for power


205

and exponential utilities, respectively. Finally, explicit solutions for a three factor model can be found in [30]. Working as in the previous examples one obtains that the value function process satisfies the SPDE (12) and that the optimal policies can be expressed in the stochastic feedback form (10). These calculations are routine but tedious and are omitted for the sake of the presentation.

5 The Forward Formulation of the Portfolio Choice Problem and the Associated SPDE In the classical expected utility models of terminal wealth, discussed in the previous section, one chooses the investment horizon [0, T ] and then assigns the utility function uT (x) at the end of it (cf. (7)). Once these choices are made, the investor’s risk preferences cannot be revised. In addition, no investment decisions can be assessed for trading times beyond T . Recently, the authors proposed an alternative approach to optimal portfolio choice which is based on the so-called forward investment performance criterion (see, for example, [38]). In this approach the investor does not choose her risk preferences at a single point in time but has the flexibility to revise them dynamically for all trading times. Investment strategies are chosen from the set A defined in (5). A strategy is deemed optimal if it generates a wealth process whose average performance is maintained over time. In other words, the average performance of this strategy at any future date, conditional on today’s information, preserves the performance of this strategy up until today. Any strategy that fails to maintain the average performance over time is, then, sub-optimal. Next, we recall the definition of the forward investment performance. This criterion was first introduced in [33] (see also [37]) in the context of an incomplete binomial model and subsequently studied in [34, 35, 38]. A rich class of such processes which are monotone in time was recently completely analyzed in [36]. We note that the definition below is slightly different than the original one in that the initial condition is not explicitly included. As the example in Sect. 6.1 shows, not all strictly increasing and concave solutions can serve as initial conditions, even for the special class of time monotone investment performance processes (see (40) in Remark 2). Characterizing the set of appropriate initial conditions is a challenging question and is currently being investigated by the authors. Another difference is that, herein, we only allow for policies that keep the wealth nonnegative. Going beyond such strategies raises very interesting questions on possible arbitrage opportunities which are left for future study. Definition 1 An Ft -progressively measurable process U (x, t) is a forward performance if for t ≥ 0 and x ∈ R+ : i) the mapping x → U (x, t) is strictly concave and increasing, ii) for each π ∈ A , E(U (Xtπ , t))+ < ∞, and E(Us (Xsπ )|Ft ) ≤ Ut (Xtπ ),

s ≥ t,

(26)

206


iii) there exists π ∗ ∈ A , for which ∗

∗

E(U (Xsπ , s)|Ft ) = Ut (Xtπ , t),

s ≥ t.

(27)

It might seem that all this definition produces is a criterion that is dynamically consistent across time. Indeed, internal consistency is an ubiquitous requirement and needs to be ensured in any proposed criterion. It is satisfied, for example, by the traditional value function process. However, the new criterion allows for much more flexibility as it is manifested by the volatility process a(x, t) introduced below. The volatility process is the novel element in the new approach of optimal portfolio choice. We continue with the derivation of the SPDE associated with the forward investment performance process. As in Sect. 3 we proceed with informal arguments and present rigorous results in the upcoming examples. To this end, we consider a process, say U (x, t), that is Ft -progressively measurable and satisfies condition (i) of the above definition. We also assume that the mapping x → U (x, t) is smooth enough so that the Itô-Ventzell formula can be applied to U (Xtπ , t), for any strategy π ∈ A and that E(U (Xtπ , t))+ < +∞, t ≥ 0. Let us now assume that U (x, t) satisfies the SPDE dU (x, t) =

1 |Ux (x, t)λt + σt σt+ ax (x, t)|2 dt + a(x, t) · dWt , 2 Uxx (x, t)

(28)

where the volatility a(x, t) is an Ft -progressively measurable, d-dimensional and continuously differentiable in the spatial argument process. We fist show that under appropriate integrability conditions U (Xtπ , t) is a supermartingale for every admissible portfolio strategy. Indeed, denote the above drift coefficient by b(x, t) =

1 |Ux (x, t)λt + σt σt+ ax (x, t)|2 2 Uxx (x, t)

and rewrite (28) as dU (x, t) = b(x, t)dt + a(x, t) · dWt . Consider the wealth process X π (cf. (6)) generated using an admissible strategy π . Applying the Itô-Ventzell formula to U (Xtπ , t) yields dU (Xtπ , t) = b(Xtπ , t)dt + a(Xtπ , t) · dWt 1 + Ux (Xtπ , t)dXtπ + Uxx (Xtπ , t)dX π t + ax (Xtπ , t) · dW, X π t 2 = b(Xtπ , t) + σt πt · (Ux (Xtπ , t)λt + ax (Xtπ , t)) 1 + Uxx (Xtπ , t)|σt πt |2 dt + (a(Xtπ , t) + Ux (Xtπ , t)σt πt ) · dWt 2 = b(Xtπ , t) + σt πt · σt σt+ (Ux (Xtπ , t)λt + ax (Xtπ , t))


207

1 + Uxx (Xtπ , t)|σt πt |2 dt + (a(Xtπ , t) + Ux (Xtπ , t)σt πt ) · dWt 2 2 π π 1 π + Ux (Xt , t)λt + ax (Xt , t) = Uxx (Xt , t)σt πt + σt σt π dt, 2 Uxx (Xt , t) (29) + (a(Xtπ , t) + Ux (Xtπ , t)σt πt ) · dWt and we conclude using the concavity assumption on U (x, t). We next assume that the stochastic differential equation dXt∗ = −

Ux (Xt∗ , t)λt + σt σt+ ax (Xt∗ , t) · (λt dt + dWt ) Uxx (Xt∗ , t)

(30)

has a nonnegative solution Xt∗ , t ≥ 0, with X0 = x, x ∈ R+ and that the strategy πt∗ , t ≥ 0, defined by πt∗ = −σt+

Ux (Xt∗ , t)λt + ax (Xt∗ , t) Uxx (Xt∗ , t)

(31)

is admissible. Notice that Xt∗ corresponds to the wealth generated by this investment strategy. ∗ From (29) we then see that U (Xt , t) is a martingale (under appropriate integrability conditions). Using the supermartingality property of U (Xtπ , t) and the martingality property ∗ of U (Xt , t) we easily deduce that if U (x, t) solves (28) then it is a forward investment performance process. Moreover, the processes Xt∗ and πt∗ , given in (30) and (31), are optimal. The analysis of the forward performance SPDE (28) is a formidable task. The reasons are threefold. Firstly, it is degenerate and fully nonlinear. Moreover, it is formulated forward in time, which might lead to “ill-posed” behavior. Secondly, one needs to specify the appropriate class of admissible volatility processes, namely, volatility inputs that yield solutions that satisfy the requirements of Definition 1. This question is challenging both from the modeling as well as the technical points of view. Thirdly, as it was mentioned earlier, one also needs to specify the appropriate class of initial conditions. Addressing these issues is an ongoing research project of the authors and not the scope of this paper. Herein, we only construct explicit solutions for different choices of the volatility process a(x, t). These choices provide a rich class of forward performance processes which exhibit several interesting modeling features. The initial condition represents the investor’s current performance criterion. The volatility process a(x, t) represents the uncertainty about the future shape of this criterion. From the modeling perspective, one can see an analogy to term structure, where the initial condition is the current forward curve as traded in the market, while the volatility captures the way the curve moves from one day to the next. However the analogy stops here. One has to develop different methods to recover the initial condition and to specify the volatility a(x, t) for the investment problem governed by (28). We stress the fundamental difference between the volatility processes of the investment performance criteria in the backward and the forward formulations. In

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the backward case, the volatility is uniquely determined through the backward construction of the maximal expected utility. The investor does not have the flexibility to choose this process (see for instance example 4.1.1 and the volatility components (24)). In contrast, in the forward case, the volatility process is chosen by the investor as the examples in Sect. 6.2 show.

5.1 Stochastic Optimization and Forward Investment Performance Process The intuition behind Definition 1 comes from the analogous martingale and supermartingale properties that the traditional maximal expected utility has, as seen from (8). However, there are two important observations to make. Firstly, the analogous equivalence between stochastic optimization and the martingality and supermartingality of the solution in the forward formulation of the problem has not yet been established. Specifically, one could define the forward performance process via the (forward) stochastic optimization problem U (x, t) = sup E(U (Xsπ , s)|Ft , Xtπ = x), A

for all 0 ≤ t ≤ s and with the appropriate initial condition. Characterizing its solutions poses a number of challenging questions, some of them being currently investigated by the authors.2 From a different perspective, one could seek an axiomatic construction of a forward performance process. Results in this direction, as well as on the dual formulation of the problem, can be found in [45] for the exponential case. The second observation is on the relation between the forward performance process and the classical maximal expected utility. One would expect that in a finite trading horizon, say [0, T ], the following holds. Define as utility at terminal time the random variable uT (x) ∈ FT given by uT (x) = U (x, T ), with U (x, T ) being the value of the forward performance process at T . Solve, for 0 ≤ t ≤ T , the stochastic optimization problem of state-dependent utility V (x, t; T ) = sup E(uT (XT )|Ft , Xt = x) AT

(32)

(see, among others, [9, 20, 22, 40]). Then, for 0 ≤ t ≤ T , the classical value function process and the forward investment performance process coincide, U (x, t) = V (x, t; T ). 2 While preparing this revised version, the authors came across the revised version of [4] where similar questions are studied.


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6 Examples In this section we provide examples of forward investment performance processes which satisfy the SPDE (28). We first look at the case of zero volatility. We then examine two families with non-zero volatility. The examples in the first family (examples 6.2.1, 6.2.2 and 6.2.3) build on the zero volatility case. The second family yields the forward analogue of the stochastic factor model presented for the backward case in example 4.1. We note that the fact that a process solves the SPDE (28) does not automatically guarantee that it satisfies Definition 1, for there are additional conditions to be verified. One can show that the solutions presented in examples 6.2.1, 6.2.2 and 6.2.3 indeed satisfy these conditions; we refer the reader to [36] for all technical details.

6.1 The Case of Zero Volatility: a(x, t) ≡ 0 When a(x, t) ≡ 0 the SPDE (28) reduces to Ux (x, t)2 1 dt. dU (x, t) = |λt |2 2 Uxx (x, t) In [38] it was shown that its solution is given by the time-monotone process U (x, t) = u(x, At ),

(33)

where u : R+ × [0, +∞) → R is increasing and strictly concave in x, and satisfies the fully nonlinear equation ut =

1 u2x . 2 uxx

(34)

The process At is given in (39) below. In a more recent paper, see [36], it was shown that there is a one-to-one correspondence between increasing and strictly concave solution to (34) and strictly increasing positive solutions h : R × [0, +∞) → R+ to the heat equation 1 ht + hxx = 0. 2 Specifically, we have the representation +∞ yx− 1 y 2 t 2 e ν(dy) h(x, t) = y 0+

(35)

(36)

of strictly increasing solutions of (35) and x 1 t −h(−1) (x,s)+ s (−1) (−1) 2 u(x, t) = − e hx (h (x, s), s)ds + e−h (z,0) dz (37) 2 0 0 for strictly concave and increasing solutions of (34). The measure ν appearing above is a positive Borel measure that satisfies appropriate integrability conditions. We

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refer the reader to [36] for a detailed study of this measure and the interplay between its support and various properties of the functions h and u. The optimal wealth and portfolio processes are given in closed form, namely, Xt∗ = h(h(−1) (x, 0) + At + Mt , At )

and πt∗ = hx (h(−1) (Xt∗ , At ), At )σt+ λt ,(38)

where the market input processes At and Mt , t ≥ 0, are defined as t t |λs |2 ds and Mt = λs · dWs . At = 0

(39)

0

Remark 1 Formulae (37) and (36) indicate that not all concave and increasing functions can serve as initial conditions. Indeed, from (33), (37), (36) and (39), we see that the initial condition U (x, 0) must be represented as x +∞ yx e −h(−1) (z,0) U (x, 0) = ν(dy). (40) e dz with h(x, t) = + y 0 0 Remark 2 One could choose the volatility to be a(x, t) ≡ kt , with the process kt being Ft -progressively measurable and independent of x, U and its derivatives. This case essentially reduces to the one with zero volatility. Indeed, we easily conclude that the process t ks · dWs , (41) U (x, t) = u(x, At ) + 0

with u and At , t ≥ 0, as in (34) and (39) solves (28). The optimal investment and wealth processes remain the same as in (38) above.

6.1.1 Single Stochastic Factor Models This is the same model as in Sect. 4.1. Using (33) we see that the forward performance process is given by t 2 U (x, t) = u x, λ (Ys )ds (42) 0

with u solving (34). Using (38) and (37) one deduces that the optimal portfolio process is given by πt∗ = −

ux (Xt∗ , At ) + σ λt . uxx (Xt∗ , At ) t

(43)

The calculations are tedious and can be found in Sect. 4 of [36]. Notice that the optimal portfolio (43) is purely myopic even though the investment opportunity set is stochastic. This is because the volatility of the investor’s performance process was chosen to be zero. This is in contrast with the one in (21). We also observe that the investment performance process U in (42) is of bounded variation while the one in (19) is not.


211

6.2 Cases of Non-zero Volatility We start with three cases of non-zero volatility. Two auxiliary process are involved, ϕt and δt , t ≥ 0. They are both independent of wealth and are taken to be Ft progressively measurable and bounded by a deterministic constant. In addition, it is assumed that δt satisfies, similarly to the process λt (cf. (3)), the condition σt σt+ δt = δt (cf. (4)) and, thus, δt ∈ Lin(σt ). Because the third case is the combination of the first two, we provide the complete calculations therein. We conclude with a fourth case which is the forward analogue of example 4.1.

6.2.1 The Market View Case: a(x, t) = U (x, t)ϕt The forward performance SPDE (28) simplifies to dU (x, t) =

1 |Ux (x, t)(λt + σt σt+ ϕt )|2 dt + U (x, t)ϕt · dWt . 2 Uxx (x, t)

It turns out (see example 6.2.3 for δt ≡ 0, t ≥ 0) that the process U (x, t) = u(x, At )Zt , with u satisfying (34), Zt , t ≥ 0, solving t

dZt = Zt ϕt · dWt

with Z0 = 1

(44)

and At = 0 |λs + σs σs+ ϕs |2 ds satisfies (28). One may interpret Zt as a device that offers

the flexibility to modify our views on asset returns. For this reason, we call this case the “market-view” case. Using (31) we obtain that the optimal allocation vector, πt∗ , t ≥ 0, has the same functional form as (43) but for a different time-rescaling process, namely, πt∗ = −

ux (Xt∗ , At ) + σ (λt + ϕt ), uxx (Xt∗ , At ) t

with At , t ≥ 0, as above. It is worth noticing that if the process ϕt is chosen to satisfy ϕt = −λt , solutions become static. Specifically, the time-rescaling process vanishes, At = 0, and, in turn, the forward performance process becomes constant across times. The optimal investment and wealth processes degenerate πt∗ = 0 and ∗ Xtπ = x, t ≥ 0. In other words, even for non-zero λt , the optimal policy is to allocate zero wealth in every risky asset and at all times.

6.2.2 The Benchmark Case: a(x, t) = xUx (x, t)δt The forward performance SPDE (28) simplifies to dU (x, t) =

1 |Ux (x, t)(λt − δt ) − xUxx (x, t)δt |2 dt − xUx (x, t)δt · dWt . 2 Uxx

212


One can verify (see example 6.2.3 for ϕt ≡ 0, t ≥ 0) that the process x , At , U (x, t) = u Yt with Yt , t ≥ 0, solving t

dYt = Yt δt · (λt dt + dWt ) with Y0 = 1

(45)

|2 ds

and At = 0 |λs − δs satisfies (28). One may interpret the auxiliary process Yt as a benchmark (or numeraire) with respect to which the performance of investment policies is measured. Next, we define the benchmarked optimal portfolio and wealth processes, π˜ t∗ =

πt∗ Yt

X∗ and X˜ t∗ = t . Yt

(46)

Then, π˜ t∗ is given by (cf. (49) for ϕt ≡ 0), π˜ t∗ = X˜ t∗ σt+ δt −

ux (X˜ t∗ , At ) + σt (λt − δt ), uxx (X˜ t∗ , At )

with At as above with X˜ t∗ solving d X˜ t∗ = −

ux (X˜ t∗ , At ) (λt − δt ) · ((λt − δt )dt + dWt ). uxx (X˜ t∗ , At )

6.2.3 The Combined Market View/Benchmark Case: a(x, t) = −xUx (x, t)δt + U (x, t)ϕt The forward performance SPDE (28) becomes 1 |Ux (x, t)(λt + σt σt+ ϕt − δt ) − xUxx (x, t)δt |2 dt 2 Uxx + (−xUx (x, t)δt + U (x, t)ϕt ) · dWt . t We introduce the time-rescaling process At = 0 |λs + σs σs+ ϕs − δs |2 ds. We define the process x , At Zt U (x, t) = u Yt dU (x, t) =

(47)

(48)

with u solving (34) and Yt and Zt as in (45) and (44). We claim that it solves (47). Indeed, expanding yields x x x ,A ,Z . , At Zt + u , At dZt + d u dU (x, t) = du Yt Yt Y t Moreover, x x x x x 1 x + ut , At = ux , At d , At dAt + uxx , At d , du Yt Yt Yt Yt 2 Yt Y t


and

d

x Yt

=−

213

x δt · ((λt − δt )dt + dWt ). Yt

Consequently, x x x d u , A , Z = − ux , At Zt δt · ϕt dt, Y Yt Yt t x x u , At dZt = u , At Zt ϕt · dWt = U (x, t)ϕt · dWt Yt Yt and

x du , At Zt Yt x x = − ux , At Zt δt · ((λt − δt )dt + dWt ) Yt Yt x 2 x x 1 + ut , At Zt |λt + σt σt+ ϕt − δt |2 dt + uxx , At Zt − δt dt. Yt 2 Yt Yt

We then deduce that

x x x ux , At Zt δt · (λt + ϕt − δt )dt + ut , At Zt |λt Yt Yt Yt x 2 x 1 + 2 + σt σt ϕt − δt | dt + uxx , At Zt − δt dt 2 Yt Yt x x , At Zt δt + U (x, t)ϕt · dWt + − ux Yt Yt = − xUx (x, t)δt · (λt + σt σt+ ϕt − δt )dt

dU (x, t) = −

1 Ux2 (x, t) 1 |λt + σt σt+ ϕt − δt |2 dt + x 2 Uxx (x, t)|δt |2 dt 2 Uxx (x, t) 2 + (−xUx (x, t)δt + U (x, t)ϕt ) · dWt 1 |Ux (x, t)(λt + σt σt+ ϕt − δt ) − xUxx (x, t)δt |2 dt = 2 Uxx (x, t) + (−xUx (x, t)δt + U (x, t)ϕt ) · dWt , +

where we used (34). The optimal benchmarked policies π˜ t∗ and X˜ t∗ are defined as in (46). Using (21) and (48) we deduce, after some routine but tedious calculations, that ux (X˜ t∗ , At ) + π˜ t∗ = X˜ t∗ σt+ δt − σt (λt + ϕt − δt ) (49) uxx (X˜ t∗ , At ) where X˜ t∗ solves d X˜ t∗ = −

ux (X˜ t∗ , At ) (λt + σt σt+ ϕt − δt ) · ((λt − δt )dt + dWt ). uxx (X˜ t∗ , At )

(50)

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6.2.4 Single Stochastic Factor Models This is the forward analogue of example 4.1. Consider a single stock and a stochastic factor satisfying (14) and (15). Let w : R × [0, +∞) → R satisfying the (forward) HJB equation 1 2 2 wt + max σ (y)π wxx + π(μ(y)wx + ρσ (y)d(y)wxy ) π 2 1 2 + d (y)wyy + b(y)wy = 0, (51) 2 for an appropriate initial condition w(y, 0). Then, for t ≥ 0, the process U (x, t) = w(x, Yt , t)

(52)

satisfies the SPDE (28) with volatility vector a(x, t) = (a1 (x, t), a2 (x, t)) with a1 (x, t) = ρd(Yt )wy (y, t) and a2 (x, t) = 1 − ρ 2 d(Yt )wy (y, t). Notice the main differences between the forward investment performance processes (52) and (48). Firstly, they are constructed by deterministic functions, w and u, that solve different pdes (see (51) and (34), respectively). Secondly, the investment performance process in (52) does not involve time-rescaling while the one in (48) does. Acknowledgements This work was presented, among others, at the AMaMeF Meeting, Vienna (2007), QMF (2007), the 5th World Congress of the Bachelier Finance Society, London (2008) and at conferences and workshops in Oberwolfach (2007 and 2008), Konstanz (2008), Princeton (2008) and UCSB (2009). The authors would like to thank the participants for fruitful comments. They also like to thank G. Zitkovic for his comments as well as an anonymous referee whose suggestions were very valuable in improving the original version of this manuscript. An earlier version of this paper was first posted in September 2007.

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Issuers’ Commitments Would Add More Value than Any Rating Scheme Could Ever Do Carlos Veiga and Uwe Wystup

Abstract This paper analyzes the evolution of the structured products market focusing on the tools available for private investors, on which they rely for the selection process. The selection process is extremely difficult because there is a myriad of products, because of the dynamic nature of the market and market participants’ actions, and because of the complexity of many of the products. We consider the existing types of tools, in particular the rating schemes that have been proposed by industry participants to provide guidance to the investor. We propose a set of properties that a rating scheme should show and check whether the existing schemes carry these properties. Our findings suggest that the existing rating schemes do not carry the desired properties. Furthermore, for the purpose of solving a highly indefinite selection process, an effective rating scheme may not exist. In light of this, we propose the introduction of a new quantity, the floor, that has a legal and financial meaning, on which issuers can also compete in addition to price and spread. Its acceptance and use would also yield standardization towards investors’ interests by excluding some pricing practices and severely limiting others. Even though very little research has been produced in this area, we believe this to be a topic of high importance in establishing guidelines for healthy industry development and regulation that upholds investors’ interests.

1 Introduction Around the world there is a growing number of securities and contracts issued and written by financial institutions. Their purpose is to offer a customized risk/return C. Veiga · U. Wystup () Frankfurt School of Finance & Management, Sonnemannstraße 9-11, 60314 Frankfurt am Main, Germany e-mail: [email protected] C. Veiga e-mail: [email protected] C. Chiarella, A. Novikov (eds.), Contemporary Quantitative Finance, DOI 10.1007/978-3-642-03479-4_12, © Springer-Verlag Berlin Heidelberg 2010

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C. Veiga and U. Wystup

profile that suits investors’ preferences. These so called structured products1 are linked to diverse underlying assets and are used by private and institutional investors alike. They cover short, medium and long term products from low risk to high risk and leverage. In Germany and elsewhere this market shows significant activity with the number of issuers surpassing ten in the most liquid underlyings. For example, in June 2008, the most active German exchange for structured products, Börse Stuttgart’s Euwax, reported 33 active issuers and more than 300,000 structured products listed. Other countries, specially in Europe and Australia, have also developed structured product markets with several issuers, thousands of products, and whose liquidity is close to 5% of the country’s stock market. In the year 2008 the structured products’ exchange traded volume, on the European exchanges members of FESE2 , amounted to €213 billion while equities volume amounted to €3,885 billion. In addition to the exchange traded volume, one should also consider the over the counter transactions of listed and unlisted structured products. These are surely a significant percentage of the total structured products trading, but for which, unfortunately, there are no aggregated statistics. The key difference between structured products and the standardized derivative contracts, i.e. exchange traded options and futures, is the fact that they are issued as securities. This means that a structured product issue has a definite number of “shares” and is bound to the dynamics of securities trading. These dynamics differ strongly from those of standardized derivative contracts specially when selling is concerned. Simply stated, a security can only be sold if it is held (either by previous purchase or borrow), while taking up a selling position in standardized derivative contracts is not hindered by that constraint. The importance of this difference is clear in light of arbitrage theory. It states that for a claim’s price (security or contract) to be coherent with the price(s) of its underlying asset(s) (that again may be securities or contracts), it is necessary that an agent be able to sell the claim short, if it is overpriced with respect to its underlying, and to buy it, if it is underpriced. However, in the case of structured products, borrowing is impossible3 and, consequently, so is short selling. Thus, there is no market force driving the price of an overpriced security towards its arbitrage theory fair price. That is, the price it would have if short selling were possible. Hence, the consequence of the impossibility of short selling is that the claim may be overpriced but may never be underpriced. However, arbitrage theory only states the overpricing can occur, not that it does occur. Though, it should come as no surprise that banks require a reward for going through the costs of issuing and 1 We

shall use the terms products and structured products interchangeably.

2 Federation

of European Securities Exchanges

3 Borrowing is impossible for several reasons, the most important of which are the unwillingness of

the issuers to lend the securities, the dispersion of holders of such products, and the nonexistence of a securities lending market for these securities. Exchange traded funds (ETFs), though being securities, are different from structured products for they have built in, in the fund’s by-laws, the borrowing possibility for their market makers.

Issuers’ Commitments Would Add More Value than Any Rating Scheme Could Ever Do

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maintaining these products and that profit is their true raison d’être. There is some research corroborating this fact by Stoimenov and Wilkens [4] and [6], and Wilkens et al. [5] that detail the dynamics of the overpricing over the life cycle of a product. These dynamics exhibit overpricing at issuance, overpricing decaying over the life of the product, significant overpricing drops after issuance, and order flow driven price behavior. One may rightfully ask also why does an investor even consider buying securities that are possibly overpriced. There are certainly several reasons for doing so but here we just state one: many investors do not have the size or will to invest in non-biased securities in a way that would replicate the structured product’s payoff. Thus, the trade-offs are ones of price versus size or price versus convenience, which are also present in any other market, financial or not. What is not similar to other markets is the inability of an investor, due to lack of information, to choose the best trade-off available. This is the core subject of this paper. So far, the efforts to produce the lacking information have been devoted to the development of rating schemes that classify and order products according to a scale. We devote Sect. 2 to assess whether such ratings do produce relevant information, to enable the choice of the best trade-off, and conclude that they do not. In Sect. 3 we develop a formal analysis of the lack of information problem, propose a solution, and show that it produces relevant information. We conclude, in Sect. 4, giving our view of the development of the structured products market in connection with the lack of information problem.

2 Rating Schemes Before analyzing existing rating schemes, we shall first state what we believe are the properties a rating should have in order to be effective in providing relevant information for the selection problem. Hence a rating should be: • focused – the rating should measure only one well defined target feature; • easily perceived – should allow for immediate perception of level and order between products; • informative – produce additional information to set already available; • impartial – consider only attributes specific to the product itself; • current – the rating should be updated to reflect changes of the input data; • robust – the rating should not be hindered by unusual or complex payoff profiles. It should be applicable to whatever product or contract. These principles are probably easier to agree upon than to fulfill. Even the wellknown and established ratings that classify the credit worthiness of issuers like the Moody’s, Standard & Poor’s or Fitch’s credit ratings do not fulfill all the principles above. Common critics are that (i) ratings react slowly to changes in the environment, (ii) rating agencies choose the timing of rating reviews to be cautious about the political impact on the subject country or company, (iii) the fact that rated subjects pay for the rating service and that sole fact may bias the judgment (similar to

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an auditor’s problem), (iv) rating agencies make significant subjective evaluations, and (v) that rating procedures are not robust enough to be standard across all industries and are not easily applicable to complex structures. This last issue has even been severely highlighted in the course of the current financial crisis. These critics put into question all principles above except the first three; credit ratings are focused solely on measuring the ability to meet future payments, are easily perceived, and do allow for decisions. Nevertheless, they are regarded by industry participants and regulators extremely useful classifications. Given the success of credit rating schemes, several institutions started to apply the same concept to distill the large quantity of information present in the structured products market. Examples of these schemes are the ones from Institut für ZertifikateAnalyse4 (IZA), Scope Group5 and European Derivatives Group6 (EDG), as are issuers’ classification schemes. We shall analyze these rating schemes in general as our analysis is focused on the foundations and concepts that underlie these schemes. By keeping the analysis general, we believe that it remains valid not only for existing schemes but also for future ones that address the same problem. For illustration purposes we do take the mentioned schemes as examples to highlight the problems and implications that arise in connection with principles above. We shall proceed by taking each principle above individually and examine what sort of procedures it rules out. Focused excludes: • a target feature created and defined within the rating process itself. Examples of such target features are the quality of a product or its appropriateness to a given investor profile. These concepts are defined within the rating process, they do not mean anything outside of it. Examples of proper target features are the ability to meet future payments or the overall cost of a structured product. These concepts exist a priori. When costs, credit rating, investor risk preferences, etc. are aggregated or composed into a single measure, the result is an arbitrary and meaningless concept that cannot be attached to anything outside the scope of the rating process. Furthermore, if such a concept were to be taken as reference, it would, at best, reflect the preferences of a theoretical investor that, for being so individually specific, no other investor could relate to. Any investor, other than the theoretical, with different preferences with respect to any of the attributes, would not rate the products in the same order or scale as the rating would. Easily Perceived excludes: • multidimensional rating assessments; • use of the same symbols to order distinct groups of products. 4 http://www.iza.de 5 http://www.scope.de 6 http://www.derivatives-group.com


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A multidimensional rating assessment fails to fulfill its very purpose since it does not map the set of products to an ordered scale. For example, a two dimensional rating, e.g. a measure of cost and another of expected return, can be sorted in an infinite number of ways by linearly combining the two measures. Thus, the ordering is left unresolved and hence the investor still lacks a clear basis for a decision. The ease of perceptiveness also excludes the use of the same symbols on several subsets of products that are not comparable with each other. Although the definition of subsets would simplify the rating process, the reuse of the same symbols would yield and implicit comparison that is not intended by the rating itself. Informative excludes: • redundant measurements of target features. A rating that orders by issue date or maturity date also does not add any information to the existing set. A uniform classification of all products also would not carry any information, as it would not order the products. Impartial excludes: • • • •

the inclusion of investor preferences; the use of valuation models; estimated parameters; arbitrary or subjective assessments.

The key to understand the impartiality concept can be found in measurement theory, see Luce et al. [3] for an in-depth reference and Ahlert et al. [1] for an application. The problem is that the inclusion of measurements of attributes that are not specific to the rated products will change the ordering and evaluation of the products. This inclusion shall never be consensual as it biases the rating towards some of the products. On the other hand, the inclusion of attributes that are specific to the product cannot be argued against for it is the product itself that is being rated. Investor preferences are evidently product non-specific. A valuation model implicitly biases the evaluations towards some products, just consider a barrier and a vanilla option in light of a model that assumes the existence of jumps and one that does not. One can very easily construct an example with two products where the two models yield different orders. The same is true for the inclusion of estimates. Estimates are sample and estimation method dependent and, furthermore, for the calibration of models to market prices, there may be several parameter sets that would calibrate the model. The same is true for arbitrary and subjective assessments that, if changed, would also change the ordering of the products. These assessments include the choice inherent to any aggregation or composition of measurements of different target features. Current excludes: • rating revision not linked to input data variability. An immediate and dramatic consequence of this principle is that the rating should be reassessed every time the input data is refreshed. Thus, if the rating depends on

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live information, e.g. product price, stock prices or option prices, the rating must also be updated live. Given the nature of the structured products market, where prices are typically overpriced, the price of the structured product is a necessary input to assess the costs embedded in it. The other necessary inputs are the prices of the underlying asset and of related derivatives needed to calculate the theoretical price. Thus, including costs in the rating assessment implies that the rating should be updated as frequently as the product price updates and as often the underlying asset prices updates. For most exchange traded structured products this makes it infeasible to include the cost estimates as an input for the rating process. The same may be said with respect to estimated data, i.e., the rating should be updated as often as the sample that underlies the estimation develops. Robust excludes: • rating processes valid only for a specific product type or class; • any specific model. The robustness requires that the rating process is a general approach valid for any product that exists or may exist. Different rating processes for different product types raise the problem of comparison across types. Furthermore, the inclusion of future products in the requirement comes from the fact that if they are not included by construction, new products may be created specifically targeted to take advantage of the limitations of the rating process. By the same token, no model may be able to properly evaluate and describe the risk of all types of products. It is, in fact, quite well known that typical models of a given asset class do not preform well when applied to other asset classes. Still on the robustness principle, one may argue that it is too demanding and should not be considered. Even the well accepted and established credit ratings do not fulfill this principle, so why should the structured products ratings do. We believe it should be upheld for the sole reason that the structured products market has seen a remarkable dynamic in its short history in terms of creation of new types of products. There is also no evidence that this trend is abating. To complete our analysis of rating schemes for structured products, we check what is left after the exclusions implied by the principles. Although no existing rating scheme belongs to the class of ratings schemes satisfying the principles above, that class may be non-empty. We are unable to produce a formal proof of the existence or the non-existence of rating schemes that fulfill the principles. We can report though that we have not been able to find one. Given the market characteristics, we believe that a rating scheme should consider the overall costs of the products, but that implies the existence of a model to calculate the theoretical price, and that, in turn, is not allowed by the principles. It would also use live data that would imply a live rating. We also fail to see how two products with the same overall costs, but with different payoff profiles, can be ordered in a non-subjective way. With respect to the rating schemes mentioned above, no single one satisfies the principles above. All three, IZA, Scope and EDG produce scores which do not measure any objective feature of the product. They all rely extensively on aggregation of measurements of both objective and subjective features, e.g., cost, risk, concept of


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the product, and information produced to describe the product. They consider cost and risk, which in turn require the choice of a model with parameters that need to be estimated and calibrated, and whose assessments are highly ephemeral and not consensual among market participants. Risk is measured by the value at risk only, even though risk may be assessed in multiple ways, yielding each of these its own order. Moreover, computing the value at risk requires a model assumption and possibly parameter assumptions on the distribution of the underlying, which is highly subjective. Though they all exhibit rating reassessement periods that are longer than two weeks. EDG and IZA even consider investor preferences as part of the rating process, as if an investor would know how to describe his or her risk profile in these terms, or check if it would match any of the predefined ones. Another perspective of the problem is to ask what is the harm in choosing a rating scheme that does not fulfill the principles. Such a choice would foster standardization and all products would still be rated on an equal basis. Even though all principles stand relevant in such a case, the impartiality principle assumes increased importance. If a rating that does not fulfill it is taken as a standard, or even enforced by regulation, that would yield only a standardization towards the (subjective and arbitrary) rating definition and not towards investors’ interests. Furthermore, even though investors still need to solve the selection problem on their own, as existing ratings are not effective in ordering products in a meaningful way, they bear their costs. Either payed directly to an agency or embedded in the price of the product (in which the issuer reflects all its costs including the rating related ones), investors end up paying for rating schemes. Therefore, we believe that a rating scheme is not the answer to bring standardization and informed investor choice to the structured products market. We believe instead that it can be achieved by introducing more tangible information, of the sort of bid-ask spreads and prices.

3 Floor The proposal we describe in this section builds on the work of Stoimenov and Wilkens [4] and [6], and Wilkens et al. [5] that describe the dynamics of the price of a structured product over its life cycle. This dynamics exhibit overpricing at issuance, overpricing decaying over the life of the product, significant overpricing drops after issuance, and order flow driven price behavior. The authors rely on the concept of theoretical value and super-hedging boundaries to establish a price reference. This price is then compared with market prices to determine the overpricing and its dynamics. To formalize these observations, without loss of generality, we assume that the issuer determines its bid and ask prices according to the functions Ask(t) = f A (t) + MarkupA (t),

(1)

Bid(t) = f (t) + Markup (t),

(2)

B

f A,B (t)

B

where is the issuer’s estimate of the product’s theoretical values, using the relevant spread sides for each variable, and MarkupA,B (t) are arbitrary functions.

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The markup functions may depend on any factor, including the total quantity sold of the product up to time t. The price policies described above generate profit for the issuers that can be decomposed in two parcels: interest and capital gains, denoted by Pi and Pcg respectively. The interest is earned on the sale price markup MarkupA (t0 ) only, for we assume f A (t0 ) was spent to purchase the issuer’s hedge. If we assume a bank account yielding an overnight rate r(i), the profit accumulated up to time t is just [t]−1 Pi (t) = (3) (1 + r(i)) − 1 × MarkupA (t0 ), i=[t0 ]

where t0 is the trade time and i running from the day of t0 , [t0 ] to the day before t, [t] − 1. It is important to note that this parcel of the profit cannot be controlled by the issuer after the initial transaction. On the investor’s perspective, the loss, corresponding to the issuer’s profit Pi , is included in his or her overall carry cost of holding the product. That cost is, to a large extent, predictable and/or bounded. For the capital gains we need to write first the capital gains or losses on the whole structured product transaction, that is Ask(t0 ) − Bid(t) = f A (t0 ) − f B (t) + MarkupA (t0 ) − MarkupB (t).

(4)

We now assume that f A (t0 ) − f B (t) is covered by the issuer’s hedge. Therefore, the issuer’s capital gain attributable to the pricing policy is just Pcg (t) = MarkupA (t0 ) − MarkupB (t).

(5)

Unlike Pi , Pcg does depend on the issuer’s pricing policy. The issuer is free to change MarkupB (t) at any point; even set it at negative values7 . On the investor’s perspective, an decrease of MarkupB (t) constitutes a loss. Such a loss is unpredictable in its size and moment. We now claim that investors are better off if the MarkupB (t) is known in advance, that is, before the investor purchases the product. Better off for the sole reason that investors would have enough information to weigh the total costs of the product against the benefits it brings them. Without the knowledge of MarkupB (t) there is a loose end in the costs side until the product’s maturity is reached, time when, by definition, MarkupB (t) is zero. Accordingly, we proceed with our analysis assuming, from this point on, that the issuer has committed to use the function MarkupB (t) and that it stated on the product’s term sheet. However, there is still one open problem. This analysis has assumed that the issuer’s estimates of the product’s theoretical value, f A,B (t), are not subject to arbitrary revisions. If they are, the commitment is hollow because f A,B (t) may include not only the issuer’s estimate of theoretical value but also hide part of the 7 This is equivalent to setting a bid price at a discount to the reference price. Stoimenov and Wilkens [4] provide evidence of this.


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MarkupA,B (t). If that is allowed to happen, we are back to the initial situation, where there is not enough information to determine in advance the issuer’s total profit. However, it is not reasonable to ask the issuer to disclose f A,B (t) for it may include trade secrets, be extremely complex and unusable by other parties. Therefore, we need to replace f A,B (t), chosen by the issuer, by new function A,B h (t), independent of the issuer’s views, such that expression (5) remains valid. In turn, this means hA (t0 ) − hB (t) is covered by the issuer’s hedge. This is easily accomplished if there is a static hedge for the structured product. Then hA,B (t) are just the prices of that static hedge portfolio, and hA (t0 ) − hB (t) is just the result from setting up and unwinding the hedge portfolio. If there is a static super hedge, and hA,B (t) is the price of the super hedge portfolio, expression (5) is still valid for all t before maturity. At maturity time T , Pcg (T ) ≥ MarkupA (t0 ) − MarkupB (T ) because the payoff of the super hedge portfolio may be greater than the payoff of the product. However, if the investor sells the structured product before maturity, the additional loss is not incurred. Thus, if there is a static hedge or a super hedge for the structured product, there are functions hA,B (t) to replace f A,B (t) that are independent from the issuer’s assessments. Functions hA,B (t) may even track a dynamic hedge (or super hedge) self-financing portfolio that the issuer is able to trade. For products that cannot be statically super-hedged there may or may not be functions hA,B (t) to replace f A,B (t). However, if a product that can be decomposed as a portfolio, with its elements only taking positive values, the bid price may track only those elements that can be statically hedged (or super hedged). In such a case, the bid and ask functions (1) and (2) would be revised as Ask(t) = hA (t) + g A (t) + MarkupA (t),

(6)

Bid(t) = h (t) + Markup (t),

(7)

B

B

with hA,B (t) the prices of the static hedge portfolio and g A (t) ≥ 0 the issuer’s estimate of the price of the elements that are not statically hedgeable. Hence, be hB (t) an hedge, super-hedge or sub-hedge, its determination is independent from the issuer’s will. Furthermore, as MarkupB (t) is defined before issuance, Bid(t) does not depend on the issuer’s will at any point in time during the life of the product. For example, consider a capital guaranteed product composed by a zero coupon bond and an exotic option. Furthermore, assume the issuer considers the Reuters’ or Bloomberg’s zero coupon bond price estimate as a reference price for hA,B (t). Thus, the product would trade at least at the zero coupon bond price, which is still better than no lower boundary at all. We say at least at zero coupon bond price because, in some situations, the bid will significantly underprice the structured product. The issuer will then, most likely, bid the structured product above the bid commitment to prevent the bid-ask spread from getting too large and to show a more competitive price. This example shows that issuers may have reasons to bid their structured products above their commitments. It is even likely that issuers do this on a consistent

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basis on all products, at least by a small amount. The reason being to avoid unintended breaches of the bid price commitments and diminish potential conflicts. This observation is what motivated us to name the issuer’s commitment as floor and not bid price commitment. From now on we will refer to it only as floor. The cases we considered so far are cases where it is simple to find a floor and where the floor does not charge the issuer with extra risks. However, the issuer is free to choose the floor, even floors that carry extra risks with them. For the cases we considered above, the term sheet of a structured product should include at least these additional clauses: • • • • • •

Floor in the Secondary Market: applicable. Floor Guarantor: legal name of entity. Floor Type: sub-hedge, exact, super-hedge. Floor Reference Price: instrument identification and price location. Initial Floor Markup: X currency units. Floor Markup Daily Decay: Y currency units.

We remark that these rules, on the one hand, exclude some pricing policies reported in Stoimenov and Wilkens [4] and, on the other hand, make some others predictable. Arbitrary pricing policies are excluded as they cannot be described by any function. This is a major difference as the issuer is no longer free to charge investors that hold their structured products in an non-disclosed-in-advance way. Pricing policies that depend on transaction volume or total outstanding quantity would have to be described in advance in a function. Furthermore, its relevant quantities would have to be made public and refreshed at a rate set by the markup definition. This is probably enough to deter issuers from including such rules in the markup definition. Markup functions may still have a non-linear decay, as the reported large decays after issuance. However, as this information is known in advance, investors may postpone the purchase of the product until that period has passed. The floor still leaves room for regular and predictable pricing strategies that are essential for the issuer to be able to profit from its products. We also make note that, the floor is a new value that should be disseminated through the information network. Just like it is done with the usual set of prices that include the bid and ask prices, the last traded price, the daily maximum and minimum, and the previous sessions’ close price. To conclude this section we cover the most common types of structured products and provide examples of static or dynamic (super) hedges. We start with a simple example of a very common structured product. The product is called index-tracker and pays off the value of an equity price index on the maturity date. The choice of the index itself as the floor reference is problematic because an equity price index is not a valid static portfolio, for it suffers from cash withdrawals by the amount of the dividends its shares pay. Therefore, if the issuer would choose this index as the Floor Reference Price, the following three clauses should be reviewed to • Floor Type: super-hedge. • Initial Floor Markup: implicit in Floor Reference Price.


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Fig. 1 Payoff profiles of common structured products

• Floor Markup Daily Decay: implicit in Floor Reference Price. Figure 1 shows payoffs for vanilla warrants, discount certificates, bonus certificates and turbo warrants. The dashed lines represent the several possible values the product may pay off, depending on a barrier monitoring. The proposals of hedge portfolios that follow, assume the existence of exchange traded options and futures on the same underlying asset and with the same maturity as the product. They also assume the availability of risk-free cash deposits for those maturities. A vanilla warrant has as static hedge an exchange traded option on the same underlying with the same strike and maturity. For call warrants, an exchange traded option with a lower strike constitutes a super hedge. The static hedge of a discount certificate is composed by: a short position on an exchange traded call, a long position on a future and a deposit of the total unused cash. A super hedge is obtained with a higher strike call. The price of bonus a certificate is always higher than the value of a portfolio with a future plus a deposit that pays out the contracted future price. A turbo warrant is a barrier option with the barrier located on the inthe-money side of the strike. There is no static hedge for it using the instruments we assumed. This is a typical case where an issuer may choose to assume a floor that introduces additional risks. Consider a turbo warrant call on a stock that does not pay dividends or on a total return index. Assume also a zero interest rate. A possible floor would be the intrinsic value of the turbo warrant, that is, just the difference of underlying price and strike. It is as if the turbo warrant were of American style, exercisable at any moment. To hedge this new liability, the issuer has to buy one unit of the underlying. If its price never touches the barrier the hedge works. If the price does touch the barrier, the issuer needs to sell the unit of underlying at the barrier level to maximize his result. At least, the issuer needs to sell the hedge above the strike to prevent a loss. However, this may not be possible because stock prices and indexes sometimes evolve in a discontinuous fashion. This is thus the extra risk this floor involves: the risk of not being able to unwind the hedge above the strike price.

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This is an example where stating a floor would generate a more valuable product and also justify charging a higher price for it.

4 Conclusion The goal of this paper is to enable investors to be able to identify the best tradeoff available in the structured products market. The trade-off is one of price versus benefit brought to the investor. To do so we analyze existing tools that claim to contribute to this identification. In particular, we survey the effectiveness of rating schemes to this purpose. We conclude ratings are not effective for they are in essence arbitrary in their definition and, therefore, are only able to produce arbitrary orderings. In order to fairly analyze the schemes, we first present a list of principles we believe every effective rating scheme should have. The rating schemes are then analyzed in light of these principles. We conclude that none of the considered schemes satisfy them. We also report to have failed to develop a rating scheme that would fulfill those principles. We proceed with a simplification of the problem by removing the benefit to the investor from the analysis. We do so because the investor’s benefit is an individual assessment that does not lend itself to modeling. We are then left with the price and realize that, even in price, there is currently no way to have a precise assessment. Fortunately price is a more tangible concept that allows for modeling and formal description. We offer a framework to study the concept and then develop a proposal that enables a clear assessment of the price side of the trade-off. The proposal is a floor guarantee until the product’s maturity. The floor is a quantity that can be freely defined by the issuer but is legally binding. It is the lowest price the issuer can bid at each moment for the structured product. In a way, it constitutes the time continuous counterpart of the discrete time commitments stated in the term sheet. The floor excludes some of the pricing policies referenced in the literature and seriously limits others. However, it still leaves room for regular and predictable pricing strategies that are essential for the issuer to be able to profit from its products. We complete the proposal with examples of application to the most common types of structured products. Having a guaranteed floor, or the lack of it, quoted by an issuer for a complex product is probably the best rating the investor can get, as the inability or unwillingness to define a floor is itself an indication of the complex balance of risks and rewards underlying the product. As to the question of whether the floor would make products more expensive, the answer is: not necessarily. On the one hand, any floor is always better than none at all (even if it is theoretically redundant) and thus should imply an extra cost. On the other hand, as explained above, it is impossible to know how expensive existing structured products really are due to their lack of floors. Therefore, the floor introduces a qualitative change that makes the products that bear it incomparable to the ones that do not. Only with a floor is a proper assessment of the cost of a product possible.


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Actual rating schemes, as we showed, are not primarily scientific constructions but instead, the result of accumulation of credibility over many years, even centuries, the most elegant scientific formulation would ever replace. As to the acceptance of these proposals, we do not expect market leader issuers to take them up promptly, as standardization may harm their margins and market share. As in any market, it is more likely that smaller players, that want to grow their market share, use these proposals as a mean to develop products that are objectively superior to the products of their competitors. Acknowledgements The author wishes to thank Millennium bcp investimento, S.A. for the financial support being provided during the course of his Ph.D. studies.

References 1. Ahlert, M., Gubernatis, G., Kliemt, H.: Kidney allocation in Eurotransplant. Anal. Krit. 23, 156–172 (2001) 2. Cabral, L.: Introduction to Industrial Organization. MIT Press, Cambridge (2000) 3. Luce, R., Krantz, D., Suppes, P., Tversky, A.: Foundations of Measurement, vol. III. Academic Press, San Diego (1990) 4. Stoimenov, P., Wilkens, S.: Are structured products ‘fairly’ priced? An analysis of the German market for equity-linked instruments. J. Bank. Finance 29, 2971–2993 (2005) 5. Wilkens, S., Erner, C., Röder, K.: The pricing of structured products in Germany. J. Deriv., Fall, 55–69 (2003) 6. Wilkens, S., Stoimenov, P.: The pricing of leverage products: An empirical investigation of the German market for ‘long’ and ‘short’ stock index certificates. J. Bank. Finance 31, 735–750 (2007)

Pricing and Hedging of CDOs: A Top Down Approach Damir Filipović and Thorsten Schmidt

Abstract This paper considers the pricing and hedging of collateralized debt obligations (CDOs). CDOs are complex derivatives on a pool of credits which we choose to analyse in the top down model proposed in Filipović et al. (Math. Finance, forthcoming, 2009). We reflect on the implied forward rates and bring them in connection with the top-down framework in Lipton and Shelton (Working paper, 2009) and Schönbucher (Working paper, ETH Zurich, 2005). Moreover, we derive variance-minimizing hedging strategies for hedging single tranches with the full index. The hedging strategies are given for the general case. We compute them also explicitly for a parsimonious one-factor affine model.

1 Introduction In this paper we gradually develop a general formula for the variance-minimizing hedging strategy for a single tranche CDO within the top-down model framework recently developed in Filipović et al. [3]. In the last decade the markets of collateralized debt obligations (CDOs) have witnessed a tremendous activity and many models have been developed for pricing and some for hedging. The current market turmoil however illustrates that mostly used approaches – typically static models, such as the Gaussian copula model – are not able to capture the dynamic nature of the model. This is important for consistent pricing and even more important for hedging. In this paper we concentrate on D. Filipović () Swiss Finance Institute, Ecole Polytechnique Fédérale de Lausanne (EPFL) and Swiss Finance Institute, Quartier UNIL-Dorigny, Extranef 218, CH-1015 Lausanne, Switzerland e-mail: [email protected] T. Schmidt Department of Mathematics, Chemnitz University of Technology, D-09126 Chemnitz, Germany e-mail: [email protected] C. Chiarella, A. Novikov (eds.), Contemporary Quantitative Finance, DOI 10.1007/978-3-642-03479-4_13, © Springer-Verlag Berlin Heidelberg 2010

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232

D. Filipović and T. Schmidt

the dynamic top down model proposed in Filipović et al. [3] and derive varianceminimizing hedging strategies. For an overview of credit risk modelling we refer to the respective chapters in [9]. The most liquidly traded CDOs are those based on so-called indices. In 2004 the CDX in North America and the iTraxx in Europe have been created. For example, the iTraxx Europe consists of the 125 most liquid investment grade corporate credit default swaps. Besides the index single tranche CDOs (STCDOs) are liquidly traded. The STCDOs allow to invest in parts of the CDO, so-called tranches, see Sect. 4 below for details. In this paper we analyse the hedging of a STCDO with the index and derive the variance-minimizing hedging strategy. Besides the hedging strategy for the general form, we compute the hedging strategy explicitly in a simple one-factor affine model. This simple model is dynamic and allows to fit any given initial term structure of CDOs perfectly. For related articles on the dynamic hedging of credit portfolio products and CDOs we refer the reader to [1]. We assume a stochastic basis (Ω, F , (Ft ), Q) satisfying the usual conditions, and where Q denotes a risk-neutral pricing measure. We consider a portfolio of credits with an overall outstanding notional normalised to 1. We follow a top-down approach and assume that the loss process t Lt = ΔLs = x μ(ds, dx) s≤t

0

(0,1]

be an I := [0, 1]-valued non-decreasing marked point process with absolutely continuous compensator ν(t, dx)dt. We let μ(dt, dx) be the integer-valued random measure associated with the jumps of L. The case of finitely many loss fractions I = { ni : i = 0, . . . , n} is a special case of the setup. We then define the (T , x)-bond which pays 1{LT ≤x} at maturity T , for x ∈ [0, 1]. In other words, this is a zero-recovery defaultable bond. Its arbitrage-free price at time t ≤ T is denoted by P (t, T , x). By construction, P (t, T ) = P (t, T , 1) is the risk-free zero coupon bond. As a consequence, P (t, T , ·)/P (t, T ) = EQT [1{LT ≤x} | Ft ] is just the Ft -conditional cumulative distribution function of LT under the T forward measure QT . Moreover, any European type T -claim on the loss process with absolutely continuous payoff function H (LT ) can be decomposed into an infinite linear combination of (T , x)-bond payoffs: H (LT ) = H (1) − H (x)1{LT ≤x} dx. (0,1]

H

Here with we denote the Dini derivative of H , which is known to be locally integrable in x (see e.g. [12, Theorem 7.29]). As a simple consequence the price πt of the claim at any time t ≤ T is given by πt = H (1)P (t, T ) − H (x)P (t, T , x) dx. (1) (0,1]

This paper is structured as follows. In Sect. 2 we derive the arbitrage free (T , x)bond dynamics, and obtain a no-arbitrage criterion as proposed in Filipović et al. [3].

Pricing and Hedging of CDOs: A Top Down Approach

233

In Sect. 3 we reflect on the implied forward rates and bring them in connection with the top-down framework in Lipton and Shelton [8] and Schönbucher [11]. In Sect. 4 we calculate the gains processes from a single tranche CDO with arbitrary detachment points. This includes the entire index in particular. It is understood that the index can be replicated by holding the respective positions in the constituent CDS. In Sect. 5 we then derive the variance-minimizing hedging strategy for any STCDO in terms of the index in general. This is then explicitly computed for a simple one-factor affine model in Sect. 6.

2 (T , x)-Bond Dynamics In this section we recap the framework for arbitrage-free term structure movements as laid out in [3]. The (T , x)-bond price is decomposed into default event and market risk: P (t, T , x) = 1{Lt ≤x} e−

T t

f (t,u,x)du

.

We assume that, for all (T , x), the (T , x)-forward rate process f (t, T , x), t ≤ T , follows a semimartingale of the form t t a(s, T , x)ds + b(s, T , x) dWs f (t, T , x) = f (0, T , x) + 0

t

+

0

c(s, T , x; y) μ(ds, dy) 0

(2)

(0,1]

where W is some d-dimensional Brownian motion. To justify the subsequent stochastic analysis we make the following technical assumptions, where O and P denote the optional and predictable σ -algebra on Ω × R+ , respectively: (A1) The initial forward curve f (0, T , x) is B(R+ ) ⊗ B(I )-measurable, and locally integrable:

T

|f (0, u, x)| du < ∞ for all (T , x).

0

The drift parameter a(t, T , x) is R-valued O ⊗ B(R+ ) ⊗ B(I )-measurable, and locally integrable:

T 0

T

|a(t, u, x)| dt du < ∞

for all (T , x).

0

The volatility parameter b(t, T , x) is Rd -valued O ⊗ B(R+ ) ⊗ B(I )-measurable, and locally bounded in the sense that sup 0≤t≤u≤T

b(t, u, x) < ∞

for all (T , x).

234


The contagion parameter c(t, T , x; y) is R-valued P ⊗ B(R+ ) ⊗ B(I ) ⊗ B((0, 1])-measurable, and locally bounded in the sense that |c(t, u, x; y)| < ∞

sup

for all (T , x).

0≤t≤u≤T , y∈(0,1]

Under these conditions, the integrals in (2) are well defined in particular. Moreover, they imply that the risk-free short rate rt = f (t, t, 1) has a progressive version T and satisfies 0 |rt | dt < ∞ for all T , see e.g. [4, Corollary 6.3]. Hence the riskt

free numeraire e 0 rs ds is well defined. However, these conditions do not imply that spreads f (t, T , x1 ) − f (t, T , x2 ), for x1 < x2 are nonnegative in general. Nonnegativity of spreads has to be established from case to case, such as in the affine model in Sect. 6 below. Denote the discounted (T , x)-bond price by Z(t, T , x) = e−

t

0 rs

ds

P (t, T , x).

Lemma 1 Under (A1) the implied dynamics of the discounted (T , x)-bond price process is given by dZ(t, T , x) = α(t, T , x) dt + β(t, T , x) dWt Z(t−, T , x) + γ (t, T , x, ξ )(μ(dt, dξ ) − ν(t, dξ )dt) (0,1]

where α(t, T , x) = − rt − λ(t, x) + f (t, t, x) −

T

a(t, u, x) du t

T 2 1 + b(t, u, x) du 2 t T e− t c(t,u,x;y) du − 1 1{Lt +y≤x} ν(t, dy) +

(3)

(0,1]

β(t, T , x) = −

T

b(t, u, x) du

(4)

t

γ (t, T , x, ξ ) = e−

T t

1{Lt− +ξ ≤x} − 1,

(5)

1{Lt +y>x} ν(t, dy).

(6)

c(t,u,x;ξ ) du

and we define λ(t, x) = (0,1]


235

The corresponding stochastic exponential representation of Z(t, T , x) reads Z(t, T , x) = Z(0, T , x) exp t

× exp × exp

α(s, T , x) ds 0

0

t

β(s, T , x) dWs −

−

1 2

t

β(s, T , x)2 ds

0

t

γ (s, T , x, ξ ) ν(s, dξ )ds 0

× 1 + γ (s, T , x, ΔLs )1{ΔLs >0} .

(7)

s≤t

In particular, we have ΔZ(t, T , x)/Z(t−, T , x) = γ (t, T , x, ΔLt )1{ΔLt >0} , which equals −1 if the loss process crosses level x at t, that is, Lt− ≤ x < Lt . This is consistent with the fact that Z(t, T , x) = 1{Lt ≤x} Z(t, T , x) for all t. Remark 1 Note that λ(t, x) in (6) is nothing but the intensity of the x-crossing time τx = inf{t | Lt > x} of L. Indeed, this becomes obvious since we can write 1{τx ≤t} = 1{Lt >x} =

t 0

(0,1]

1{Ls− +y>x} 1{Ls− ≤x} μ(ds, dy).

(8)

Moreover, conversely to (6), λ(t, x) uniquely determines ν(t, dx) via ν(t, (0, x]) = λ(t, Lt ) − λ(t, Lt + x),

x ∈ (0, 1],

(9)

where we define λ(t, x) = 0 for x ≥ 1. Furthermore, λ(t, x) is non-increasing and càdlàg in x for any t by (9). As a corollary of Lemma 1, we obtain the no-arbitrage drift condition from [3, Theorem 3.2]: Corollary 1 No-arbitrage, that is, Z(t, T , x) is a local martingale for all (T , x), holds if and only if t

T

a(t, u, x) du =

T 2 1 b(t, u, x) du (10) 2 t T e− t c(t,u,x;y) du − 1 1{Lt +y≤x} ν(t, dy), + (0,1]

rt + λ(t, x) = f (t, t, x) on {Lt ≤ x}, dt ⊗ dQ-a.s. for all (T , x).

(11)

236


Proof of Lemma 1 As in the proof of [3, Theorem 3.2] we decompose p(t, T , x) = − tT f (t,u,x) du as e T 2

T dp(t, T , x) 1 a(t, u, x) du + b(t, u, x) du = f (t, t, x) − p(t−, T , x) 2 t t T e− t c(t,u,x;y) du − 1 ν(t, dy) dt + (0,1]

T

−

b(t, u, x) du · dWt

t

T e− t c(t,u,x;y) du − 1 (μ(dt, dy) − ν(t, dy) dt) .

+ (0,1]

Note that we can write, as in (8) t 1{Lt ≤x} = 1 + 0

(0,1]

(−1{Ls− +y>x} 1{Ls− ≤x} )μ(ds, dy).

Integration by parts thus gives d(1{Lt ≤x} p(t, T , x)) = 1{Lt− ≤x} dp(t, T , x) + p(t−, T , x) d1{Lt ≤x} + d[1{Lt ≤x} , p(t, T , x)] = 1{Lt− ≤x} p(t−, T , x) + p(t−, T , x) (0,1]

+ p(t−, T , x)

(0,1]

dp(t, T , x) p(t−, T , x)

(−1{Lt− +y>x} 1{Lt− ≤x} ) μ(dt, dy) T e− t c(t,u,x;y) du − 1 (−1{Lt− +y>x} 1{Lt− ≤x} ) μ(dt, dy)

dp(t, T , x) = 1{Lt− ≤x} p(t−, T , x) p(t−, T , x) T − e− t c(t,u,x;y) du 1{Lt− +y>x} μ(dt, dy) (0,1]

= 1{Lt− ≤x} p(t−, T , x)(D(t) dt + dN (t)) where the local martingale part is given by

T

dN (t) = −

b(t, u, x) du · dWt

t

+

(0,1]

e−

T t

c(t,u,x;y) du

1{Lt− +y≤x} − 1 (μ(dt, dy) − ν(t, dy) dt),


237

and the drift part is T 2 1 D(t) = f (t, t, x) − a(t, u, x) du + b(t, u, x) du 2 t t T e− t c(t,u,x;y) du − 1 ν(t, dy) +

T

(0,1]

e−

−

T t

c(t,u,x;y) du

(0,1]

1{Lt +y>x} ν(t, dy)

T 2 1 = f (t, t, x) − a(t, u, x) du + b(t, u, x) du 2 t t T e− t c(t,u,x;y) du −1 1{Lt +y≤x} ν(t, dy) − +

T

(0,1]

(0,1]

1{Lt +y>x} ν(t, dy).

t

Note that the last summand equals λ(t, x). Discounting by e 0 rs ds yields (3)–(5). The stochastic exponential representation (7) is standard, see e.g. [7, Sect. I.4f].

3 (T , x)-Forward Rates In this intermediary section, we briefly reflect on the corresponding forward rates and discuss their relation to some other top-down approaches. Note that f (t, T ) = f (t, T , 1) is the risk-free forward rate. Equation (11) states that the no-arbitrage property of P (t, T , x) implies that the short rates equal the sum of risk-free short rate plus τx -intensity. In a heuristic manner, we can carry this property over to the forward rates: 1 T Q [LT +ΔT > x | LT ≤ x, Ft ] ΔT →0 ΔT

f (t, T , x) − f (t, T ) = lim

(12)

where QT denotes the T -forward measure. Whence f (t, T , x) − f (t, T ) is the QT forward transition rate prevailing at date t for L to jump at T from below or equal to above level x. Indeed, for the sake of simplicity, let us for the rest of this section assume zero risk-free rates f (t, T ) = rt = 0. Then, assuming a continuous term structure T → f (t, T , x), we obtain 1 P (t, T , x) − P (t, T + ΔT , x) ΔT →0 ΔT P (t, T , x)

f (t, T , x) = lim

1 E[1{LT ≤x} − 1{LT +ΔT ≤x} | Ft ] ΔT →0 ΔT E[1{LT ≤x} | Ft ]

= lim

238


1 E[1{LT ≤x} 1{LT +ΔT >x} | Ft ] ΔT →0 ΔT E[1{LT ≤x} | Ft ]

= lim

= lim

ΔT →0

1 Q[LT +ΔT > x | LT ≤ x, Ft ], ΔT

which is (12).

3.1 Relation to the Top-Down Model in Lipton–Shelton [8] Our approach can be brought in connection with the top-down model in Lipton and Shelton [8, Sect. 6.2], which is based on Schönbucher [11], as follows. Suppose, as in [8], that the risk-free rates f (t, T ) = rt = 0, and that the credit portfolio consists of Nc credits with nominal 1 each, and the loss process can only assume fractions i/Nc , i = 0, . . . , Nc . Then f (t, T , x) = f (t, T , i/Nc ) for all i/Nc ≤ x < (i + 1)/Nc . If, moreover, there are no simultaneous defaults, with the sole exception of a systemic default; that is, LT can either jump from i/Nc to (i + 1)/Nc or to 1. Then, view of (12), we obtain with the notation of Lipton and Shelton [8, Sect. 6.2]: l≤[Nc x] pl|m (t, T ) n>[Nc x] aln (t, T ) f (t, T , x) = l≤[Nc x] pl|m (t, T ) p[Nc x]|m (t, T )a[Nc x] (t, T ) + l≤[Nc x] pl|m (t, T )b(t, T ) = 1{[Nc x]

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